Interest rates and inflation play a pivotal role in financial planning and investing. Every asset and liability on a family’s balance sheet is directly influenced by these factors, and all financial projections must make future rate and inflation assumptions to hope to achieve any degree of accuracy. For several decades, rates and inflation have been falling, which has served as a potent tailwind for traditional assets: stocks, bonds and real estate, while also compelling the typical household to take on high debt loads at the cost of savings. So what’s the problem? In my estimation, a majority of financial plans and investment portfolios today are geared to perform well only in a continuation of this backdrop. The financial implications of a changing landscape, should it occur, would badly impact these plans and portfolios.
For nearly 40 years, interest rates and inflation have been falling. The 10-year Treasury yield peaked at 16% in 1981, and hit a low of 1.4% in 2016, and has been gradually rising to 3.2% today. Whenever a trend in financial markets persists for as long as this downtrend in rates, it becomes increasingly perceived as a permanent reality. And yet, a cursory look at the history of rates shows that this is unlikely. For example, rates rose from the early 1940s until the early 1980s, moving from 2% to a peak of 16%. This trend accelerated in the 1970s and had, by the early 1980s caused a remarkable decrease in asset prices and valuations, particularly in inflation-adjusted terms.
When that previous cycle reached its crescendo in 1982, most investors could not conceive of an environment where rates and inflation did anything but go up. This assumption led most to see little opportunity in assets, and debt was a four letter word. This negative backdrop, paradoxically, served to create an incredibly fertile ground of investment opportunity. Asset valuations, across the board, were astoundingly cheap. One didn’t need to forecast when rates would peak, just recognize that assets were cheap, and have the imagination to conceive of a world were interest rate and inflation trends could reverse. Those conditioned to believe that a world of rising rates and inflation were a permanent condition subsequently missed a monumental 20 year bull market for most asset classes.
What about today? In many ways, the landscape is the polar opposite of the early 1980s. Interest rates, though slowly rising, are still near historically low levels which has led to a dramatic rise in asset prices and valuations. Rising asset prices combined with falling rates has also incentivized households to increase debt levels and dramatically reduce savings rates. The broad consensus seems to believe that central bankers will simply not let rates rise to a level which would negatively impact asset prices.
Sound financial and investment planning, however, is always about asking the fundamental question: “What if I’m wrong?” Should today’s pervasive investor assumptions prove misguided, they could result in very poor financial and investment outcomes. A good financial advisor knows better than to make forecasts, particularly about interest rates. Nonetheless, most clients would be better served working with an advisor who can conceive of a change in financial conditions and build plans and portfolios that can better navigate a range of financial outcomes, and aren’t geared to just a continuation of the status quo. The impacts of a potential change in the behavior of rates and inflation would have a profound impact on almost every aspect of a household's finances. Don’t settle for a generic financial plan and investment portfolio built by an advisor that can’t conceive of a changing environment. Now is a particularly good time to take another look at your financial plan, your investment portfolio and, quite frankly, your financial advisor.