As 2018 begins investors try to decide what the best investments are to get into. Last year it was marijuana stocks and technology companies. Will 2018 repeat the same trend? Probably not. When the economy grows faster the chair of the Federal Reserve tends to raise interest rates. Given how the GDP growth in the United States was over 3% for the two most recent quarters it is most likely that further rate hikes are in the cards for this year.
The best stock sector to benefit from rising rates is the financial industry. Companies such as JPMorgan Chase (NYSE:JPM) and Citigroup Inc (NYSE:C) have P/E ratios around 15 times which is a big discount compared to broad market indexes such as the Dow Jones Industrial Average, or the S&P 500 index which has a P/E ratio in the twenties range. Citigroup suffered a beating during the financial crisis of 2008 but has nearly doubled since early 2016, due to cutbacks and refocusing on its core business. For the last few years the stock has been increasing its dividends from 1 cent per share per quarter in 2014, to 5 cents in 2015, 16 cents in 2016, and 32 cents in 2017.
But higher interest rates can also be risky for Americans who have a lot of investment and consumer debt. Some people think leverage is risky because if interest rates go up then investors will feel the pain. But if we believe the following premises to be true, then we can see it’s not as doom and gloom as the critics make it out to be.
- Debt used for financial leveraged usually gets paid down over time, even if the debtor makes just the minimum installed payments. As more time goes by the risk of financial insolvency decreases. I used to have $530,000 of debt in 2015, but now it’s down to $460,000. This means I can service higher interest rates today than in 2015.
- Investors likely will earn more money over time due to increasing human capital and more investment earnings from dividends and interest, assuming they invest in dividend growth stocks and other relatively safe and proven investment strategies and do not speculate or take money out of their portfolio.
- Interest rates tend to go up gradually. The Fed’s mandate depends on labor, inflation, currency value, and other economic data which doesn’t change drastically overnight. This means rate hikes will be done gradually over time at small increments of 0.25% or so.
Give the above information, I think it’s reasonable to borrow money if it’s appropriate to invest in assets that will likely produce higher returns than the cost of borrowing without fearing an imminent disaster that will lead to a negative financial outcome.
If the Federal Reserve hikes rate again by 0.25% today then my average interest rate will be 3.3%, which is still relatively low. But it will increase my cost of borrowing to $1,316 per month. If this happens then instead of investing 25% of my monthly savings, and using the remaining 75% to pay down debt, (which is what I’m doing now,) I will devote 50% of my savings to pay down debt and invest the remaining 50% until my interest expense is lowered to a more affordable level, such as $1,250/month. I would consider $1,500/month of interest payment to be too much for me. So before it ever gets to that level I will sell some of my investments and use the money to pay down my highest interest debt. The strategy here is to balance debt with investments. If the cost of borrowing is high then more savings should go towards reducing debt. But if the cost of borrowing is low then more savings can be allocated to new investments. One advantage of buying financial stocks such as JPM or C is that if interest rate rises, then historical data shows that financial stocks will also be going up. So if investors need to sell assets to pay down debt because the cost of borrowing is high, at least they are likely to sell their stocks at a profit.