The Federal Reserve has been consistently -- and aggressively -- raising interest rates for about a year now, seeking to lower the temperature of the economy and reduce runaway inflation. It started in March 2022, with a 25-basis-point increase from near zero at the time. Eight hikes later, the benchmark federal funds rate is now in the 4.75% to 5% range -- the highest since the 2007 housing market bubble.
The Fed's goal of lowering inflation to its target range of 2% is starting to work. The inflation rate went from 8.5% in March 2022 to a high of 9.1% in June 2022, but it has steadily declined since then. In January, it was 6.4%; in February, it was 6%; and last month, it dropped to 5%. It is still significantly higher than the 2% target, but it is moving in the right direction.
With inflation dropping, the Fed has slowed the pace of rate hikes. At its last meeting in March, it raised rates by just 25 basis points. Plus, in the wake of the banking crisis and the collapse of two banks, the Fed's stance on rate increases may have become less hawkish.
Of course, things can change, depending on inflation and other macroeconomic factors, and there's nothing investors can do about that. But you can control how you approach investing in a high interest rate environment. First, let's take a look at where things might be headed.
Rate hikes winding down?
While rising interest rates have indeed worked to tame inflation, they have also slowed the economy considerably, from an abnormally high 5.9% post-pandemic annual gross domestic product (GDP) growth in 2021 to 2.1% in 2022. Over the next two years, the effects of rate hikes on the economy should become even more apparent, with real GDP growth projected to be under 1% in both 2023 and 2024.
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As mentioned, the Fed seems to be winding down its rate hikes as its "dot plot" -- consensus projections on rates and other economic indicators -- would suggest. The consensus indicates that rates will peak at 5.1% in 2023, and start to decline in 2024, down to 4.1% by the end of next year.
As for the stock market, the S&P 500 is already up 7% year to date to just over 4,100, and many analysts project it to finish in the range of 4,100 to 4,200 for the year, which would be a modest 5% to 10% gain.
So given this backdrop, what should an investor do?
Stay calm, and focus on fundamentals
First and foremost, you must remember that this volatility and uncertainty we are seeing is a short-term phenomenon, so there is no point in making rash changes to your portfolio. The investments you've made over the years have been made with an eye on long-term performance, so nothing should shift from that perspective.
Now, the times may warrant alterations at the margins, but only if things have materially changed for those companies and those changes have impacted their earnings power. You may also be wary of more speculative plays made during the bull market that have failed to generate earnings and are still overvalued.
What's more important now than it has been in a while is a focus on fundamentals -- those metrics that indicate a stock's intrinsic value. This includes earnings and revenue growth consistency, expenses, return on equity, operating margin, the price-to-earnings ratio, free cash flow, and return on invested capital, among others.
Last year, the S&P 500 lost about one-fifth of its value while the Nasdaq 100 declined by nearly one-third. The average P/E ratios for those benchmarks are roughly 18 and 25, respectively, which are closer to historical ranges. A stock that's not generating earnings or has a P/E ratio that's significantly above its historical average may not fare as well if the market experiences another correction or if there is a recession.
Interest rates are the tool that the Fed will use to walk this fine line to hopefully avoid both. Whether it can do so successfully is out of your control, but you can help yourself by being prepared and maintaining a focus on the long term.
