Welcome to Season 3, Episode 4 of Meet the Expert® with Elliot Kallen!
In this episode, Elliot Kallen brings on Bob DeRochie to discuss the current state of the economy, inflation, interest rates, and investment strategies for both bonds and equities. From playing defense in fixed income to focusing on value and healthcare in equities, this episode provides valuable guidance for investors seeking to make informed decisions in an ever-changing market.
Meet Our Guest
Senior Vice President | First Trust Advisors
Bob DeRochie has been an SVP and Fixed-Income Specialist with First Trust for over 17 years. He received his Bachelor’s in Economics/Finance from Alfred University and received his MBA from the University of Bridgeport. First Trust Portfolios L.P. and its affiliate First Trust Advisors L.P. were established in 1991 with a mission to offer trusted investment products and advisory services. They are inspired every day by how financial professionals and their customers use our products and services to define goals, solve problems and develop long-term strategies. First Trust prides itself on working diligently and respectfully to deliver superior products, services, and results.
The Impact of Interest Rates on the Economy
For almost 40 years, interest rates have been a critical component of the U.S. economy. During this time, interest rates have gone through various highs and lows, with the most significant change happening in the past two decades.
Interest rates have been at an all-time low, which has led to a consensus that an increase in interest rates will destroy the economy. However, when we look back at the historical context, we realize that interest rates at this point are more like neutral factors.
Understanding the Current Situation, National Policy, and the Future
Currently, the Federal Reserve has raised interest rates due to inflation caused by the COVID-19 pandemic. This increase has caused many investors, money managers, and economists to predict hard times ahead for the economy. However, the real question is when and how bad will this recession be. While it is true that we will go into a recession, the severity of it is still unknown.
As the market tries to predict the impact of rising interest rates, national policies are being put in place to ensure that the economy does not suffer too much. One way to combat the negative effects of a recession is by being proactive and addressing the issue of inflation before it gets out of control. This strategy will help in preventing a significant downturn in the economy.
Inflation and the Impact of Covid-19
The COVID-19 pandemic and subsequent economic shutdowns caused significant disruptions to the supply chain, leading to shortages and increased demand. To address the economic downturn, the government injected $5 trillion into the economy through various stimulus programs. While this helped boost spending, it also led to increased inflation.
The Federal Reserve has raised interest rates to combat rising inflation, but it has not been as effective as anticipated. The market is trying to predict where inflation will land, but there are several factors driving it, including energy prices, wages, and rent.
Energy Investment Opportunities on the Horizon
While there is a battle going on in the market about where inflation will land, there are still opportunities for investors. As we move forward, it is essential to keep an eye on the factors that drive inflation and make investment decisions accordingly. Energy prices are expected to rise, and investing in energy can yield returns. Additionally, wages are expected to continue to rise due to inflation, and investing in companies that pay higher wages can be a sound investment strategy.
Interest Rate Hikes and the Impact of New Data
The Federal Reserve has already raised interest rates 18 times in increments of 25 basis points, and more rate hikes are expected in the future. While the pace of hikes may slow down, the Fed still has more work to do, and they will continue to raise rates.
New data, such as recent job numbers, can have an impact on the Fed’s decision to raise rates. While unexpected job growth may seem like a positive thing, it can create more challenges for the Fed, forcing them to continue to raise rates.
Is This Good or Bad for Individual Investors?
The rise in interest rates can have both positive and negative effects on individuals and investors. On one hand, borrowing money for things like a house or a car becomes more expensive. On the other hand, investors can earn more significant returns on their investments, making it an attractive opportunity.
Playing Defense in the Fixed-Income Market
In the last year, the fixed-income market had significant fluctuations, with some bonds dropping double-digit returns. To play defense, investors need to be cautious and consider various risks.
When investing in fixed income, it is essential to understand the various risks, including interest rate risk, credit risk, duration, spread volatility, and liquidity. These risks can have a significant impact on the value of the investment and require a financial advisor’s guidance to navigate.
The Importance of Professional Guidance
While interest rate risk is significant, other risks, such as credit risk and duration, can also impact investment value. To navigate these challenges successfully, investors need the guidance of financial professionals who can help them make informed decisions.
Where to Invest in the Bond Market
Investors can consider short-term investments with low risks, such as corporate bonds or two-year bonds. One-year T bills are also an option, with a current rate of 4.70%.
Long-term bonds, such as 10-year bonds, may not be a wise investment due to too many unknown variables, such as inflation rates. The bond market is in a different environment than ten years ago. It is essential to play defense in the current market environment and wait for more data before making any significant investment decisions.
Focusing on High-Yield, Mortgage, and Convertible Bonds
In the current market environment, playing defense is essential. Investors can consider high-yield, mortgage, and convertible bonds to reduce risk.
Going into a recession, there is a risk of higher bond defaults. Companies like Bed Bath & Beyond have filed for bankruptcy, causing bondholders to lose their investments. With the potential for higher defaults in the next two years, it may or may not be worth the risk to invest in high-yield bonds.
High yield, mortgage, and convertible bonds may be options to reduce risk. However, with the potential for higher defaults in the next two years, it’s important to proceed with caution and consider all risks before making any significant investment decisions.
Equity Market Sectors to Consider
For the equity market, consider investing in value, healthcare, biotech, and energy stocks, as they are good defensive plays. These sectors are expected to perform well during the looming recession. The key takeaway is that investors need to be cautious in the current market and consider playing defense to minimize risks. Making a 5% return without taking a lot of risks is considered a victory in this market.
Investing in Commodities: Be Patient and Cautious
The current challenge lies in the potential for demand destruction, which could cause commodity prices to decrease due to decreased demand for building materials, gold, and other commodities. However, despite this risk, we believe that commodities still offer value, especially given recent pullbacks.
While investing in commodities may require patience and a long-term strategy, we view them as an attractive option, including energy commodities. Our actively managed commodity strategies have performed well, and we recommend taking a slow and measured approach to invest in this area. Rather than diving in headfirst, we suggest easing in gradually and averaging over time to minimize risk.