How to Invest in a 'Higher for Longer' Rate Backdrop

By Ian Salisbury May 1, 2024 Barrons

Just a few months ago, Wall Street was convinced that the story of 2024 would be all about interest-rate cuts. We're now adjusting to a "higher for longer" world, with prospects for significant cuts all but vanishing.

Fortunately, there are plenty of ways to position your portfolio. And there's a compelling case for building it like a barbell: On one side, own cyclical stocks that do well in a strong economy. On the other, hold some defensive stocks and sectors, in case of economic trouble. Use bonds for income and stability in the middle.

The barbell should work since the economy is both running hot and prone to cooling as the Federal Reserve keeps rates higher for longer than had been expected heading into the year. "The economy is still humming," says Brian Nick, senior investment strategist at research firm Macro Institute. "But there are signs the humming will turn to a low whisper. You need to be prepared."

The stock market is shrugging off elevated rates, up around 6% this year. Bonds have been a pain point: The iShares Core U.S. Aggregate Bond exchange-traded fund is down 3% this year on a total return basis. It's even worse in long-bond land, where the iShares 20+ Year Treasury Bond ETF is down 10% in total.

One concern about owning a market index fund is the dominance of the "Magnificent Seven" group of tech stocks. Following blowout years, they represent about 30% of the index, up from about 20% before the pandemic. The craze over artificial intelligence has fueled massive gains for stocks like Nvidia and Microsoft, but others in the group are faltering. Apple, facing a slowdown in China and perceived to have missed opportunities in AI, is down 12% this year; Tesla, hit by slowing electric-vehicle demand, has shed 20% of its value, though it has been recovering lately.

Cutting your exposure to Big Tech is like buying some insurance if the market's leadership shifts to value areas and sectors that have trailed during this rally. What's more, there are plenty of stocks beyond headline-making tech names that benefit from today's economic climate.

Consider megabanks and other large-cap financial stocks. Higher-for-longer rates may frustrate borrowers, from small-business owners to home buyers, but they can lift profits on loans. The nation's biggest banks, including JPMorgan Chase and Citigroup, have seen net interest income surge by double-digits since the Fed began its inflation-fighting campaign.

Wall Street had a mixed reaction to banks' first-quarter earnings, and megabanks face stiffer capital requirements under "Basel III" rules in the works. But James St. Aubin, chief investment officer at Sierra Investment Management, favors the sector, expecting profit margins to remain strong. Despite competition from money-market funds yielding 5%, the megabanks still offer basically no interest on consumer deposits—Chase's basic savings account yields 0.01%. That should help them keep loan funding costs low and maintain healthy margins on loan portfolios.

At the same time, mortgage and credit-card borrowers are paying some of the highest rates in a generation. The longer rates remain high, the longer big banks will benefit from the mismatch. "As the prospect of rate cuts continues to get pushed out, that will support net interest margins," St. Aubin says.

Industrials are another area where investors can find value amid higher rates, especially while the economy remains strong. Higher rates make it difficult for companies and consumers to finance large-equipment purchases. But the "industrials" moniker covers everything from airplane manufacturers to garbage collectors and payroll companies. Spending in plenty of industrial areas remains strong, especially for new chip plants and green energy projects, says Jeffrey Muhlenkamp, portfolio manager of the $235 million Muhlenkamp fund.

On the other side of the barbell, consider some defensive sectors that should hold up in a weak or slowing economy. The market brushed off disappointing first-quarter GDP growth of 1.6%, but that attitude may not last if more signs of weakness settle in.

Utilities have been stung by the high rate environment, which makes it costlier to finance projects like power plants. Yet that dynamic has made these stocks cheaper than any time since the 2008-09 financial crisis, according to Morningstar.

The sector, which tends to be resilient during bear markets, has growth drivers, too, including clean-energy grid upgrades and the knock-on effects of kilowatt-chugging AI data centers. "There's a lot of need for electricity going forward," says Morningstar strategist Andrew Bischof.

Real estate investment trusts, or REITs, are another battered area likely to shine as rates come down. The sector is off an average of 7% this year, but that has lifted yields. And some REITs have secular tailwinds, irrespective of the economic cycle.

Bonds for Ballast and Income

Bonds remain a sore spot for many investors following some losses, even after factoring in interest income. The consolation is that yields remain generous, with payouts of 5% to 8% attainable. The trick is to take advantage of those yields without risking additional losses if long-term rates continue to ratchet up.

When it comes to Treasuries, the obvious solution is to go short: T-bills maturing in one month to a year pay north of 5%. Two-year notes yield 4.7%, and you can lock that in until mid-2026—long past all but the most conservative forecasts for interest-rate reductions. "You are going to get a higher yield and some protection" against declining payouts, says Joseph Kalish, chief global macro strategist for Ned Davis Research.

There's more yield in high-quality corporate bonds.

As always, the juiciest yields are in lower-credit or "junk" territory. Floating-rate funds own short-term corporate loans typically packaged into bonds rated below-investment grade.

For now, the markets don't see much trouble: junk-bond spreads, which measure the extra yield these bonds offer over Treasuries, are narrower than they've been since early 2022. That suggests bond investors aren't worried about a spike in defaults. "Spreads have been well behaved," says St. Aubin. "It underlines that the growth outlook is good."

Write to Ian Salisbury at ian.salisbury@barrons.com

This Barron's article was legally licensed by AdvisorStream.


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