So, the Federal Reserve has decided to cut interest rates by half a percent or 50 basis points to 5%. It was a lot more than most people were expecting. That should delight the market, shouldn’t it? After all, a bigger-than-expected weight has been lifted off stock markets around the world. An even bigger burden has been removed from emerging-markets currencies.
But guess what? Some quarters of the market are far from delighted. Sceptics think that the Fed has been forced to make a bigger cut in the Fed fund rate because the American economy could be heading into recession. You just can’t make this stuff up. The Fed can’t win whatever it has decided to do.
But here’s the thing: what the Fed does shouldn’t matter a jot to investors with well-balanced portfolios. A portfolio that is properly constructed should be able to cope with every economic condition that include high interest rates, low interest rates, rapid economic growth, recession or even geopolitical events.
Consider banks. High interest rates are generally good for lenders because they can make supersized profits quite effortlessly. It could be a good time to own bank shares. But when interest rates are heading lower, banks must work harder to make up for a narrower net interest margin by extending more loans.
Now consider Real Estate Investment Trusts or REITs. Unlike banks, they prefer lower interest rates because they use loans to amplify their profits. When interest rates are high, more of their rental revenue is used to make higher interest payments. But when interest rates are low, more rental revenue could flow into the pockets of unit holders through bigger distributions.
So, here’s the thing. Should we be continually jumping back and forth from banks to REITs every time there is a change in interest rates? We could. But what a dreadful waste of time and energy, not to mention the fees and commissions we will have to fork out whenever we do so.
A well-balanced portfolio that includes, say, both banks and REITs could mean that any weakness in the performance of banks could be compensated by strength in the REITs, and vice versa. Additionally, the portfolio could continue to generate reliable income that can be used to buy more shares in weakened sectors.
The point is that economic cycles and the ensuing interest rate movements are part and parcel of investing. They should be seen as opportunities rather than threats. And the best way to tame the interest-rate beast and to overcome doubt is to build a robust portfolio. Otherwise, we end up getting pushed from pillar to post that doesn’t benefit anyone apart from brokers who relish in sowing doubt.
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Disclosure: David Kuo does not own any of the shares mentioned.
