What Happens if Interest Rates Rise?

The lower interest rates go, the less people worry about rising rates.

When rates are at 4% for example, it seems entirely possible that they can go to 7%. “Oh no, what’ll happen to my principal?”

But with rates hovering around 1%, the idea that rates are going to shoot to 4% or higher isn’t front and center. Right now, investors are saying, “Oh no, what happened to my income?”

Obviously bonds are very sensitive to changes in interest rates, but they’re hardly alone in this manner. I thought this snippet from GMO’s most recent quarterly letter, which hits on this topic, was worth sharing.

Allocating to Value stocks also helps lower the duration of your portfolio. Value tends to have a higher dividend yield, so you get more of your return earlier than with Growth stocks, where you are more dependent on cash flows further into the future.

I don’t know that low rates are responsible for growth outperforming value, and I also don’t know that rising rates would cause this to reverse. But either way, I thought this idea that value stocks could lower the duration of your portfolio by returning cash earlier was interesting. The chart below shows the dividend yield of large growth compared with large value.

What can change the growth>value dynamic that’s been in place for the last few years? Hard to say. A simple yet unsatisfying explanation is investor preferences change. In a low growth world, it makes sense to pay up for businesses that have explosive growth. But what if investors end up paying too much for growth that doesn’t materialize? In that case, maybe they’ll favor stocks that, while aren’t growing their earnings as fast, are trading at an attractive price relative to their fundamentals. It’s hard to imagine it now, but that’s often where the best opportunities often lie.