The stock market fell this week after the Consumer Price Index for August indicated that inflation was higher than expected. Coupled with a decent jobs report, this inflation data opened the door for continued rate hikes by the Federal Reserve. Rising rates will have a handful of major impacts across different asset classes, and investors need to understand how they all fit together in a retirement plan.
Your 401(k) will drop in the short term
Rate hikes are wreaking havoc on the stock market.
It’s not always a perfect relationship, but the stock market tends to move in the opposite direction of interest rates. When recessions hit and unemployment rises, the Federal Reserve typically lowers interest rates. That drives economic growth and encourages investors’ appetite for risk, which drives stocks higher.
Inflation tends to rise if expansionary conditions persist long enough. Tight labor markets drive wages higher, and strong consumer sentiment gives companies pricing power. To combat inflation, the Fed raises interest rates. When the cost of borrowing money rises, businesses stop hiring, the housing industry slows, and consumer spending falls. All of this signals investors to reduce portfolio risk, and stocks often fall.
If you have watched the market since the pandemic began, then you have witnessed all of this in real life. A sudden drop in economic activity prompted aggressive action from central banks, flooding economies around the world with cash. This supported business activity and employment, and fueled an 18-month bull market.
Low interest rates and high employment combined with other factors to drive exceptionally high inflation as we head into 2022. Consumer prices outpaced wages, becoming a threat to economic stability and forcing the Federal Reserve to raise rates. As expected, the stock market responded with high volatility and losses across all major indices. Growth stocks have suffered steeper losses than value and dividend stocks.
That’s the most immediate and visible impact of tight monetary policy for most retirement plans. Equity positions have taken a beating, and it is impossible to know if we have already bottomed out. There is a chance that all future gains are already priced into stock valuations, and the Fed’s upcoming announcements will do no further damage. However, any hint that monetary tightening will outperform expectations is almost certain to push stocks lower. Slow economic growth is likely to be an additional drag on stocks in the coming quarters.
Investors should prepare for increased volatility in their retirement accounts. Don’t sell stocks that are temporarily down unless you have to. If you have more than 15 years until retirement, it’s still appropriate to invest for growth. If you’re approaching retirement, make sure you’ve established the proper allocation of bonds and other low-volatility assets.
Revenue yields are rising
The stock sell-off will hurt retirees, but there’s a major upside: higher rates on savings and fixed-income investments. That’s a reversal of the lowest rates of the last decade, which created a serious challenge for retirement planning.
For much of the 2010s, bonds didn’t earn as much interest as they used to, and rates on savings accounts and CDs were low, along with the average dividend yield on major stock indices. Retirees needed to accumulate more assets to generate the same amount of investment income. The problem was so bad that many financial advisers are calling for the 4% Rule to be revised downwards.
This problem only got worse after COVID-19. Interest rates on Treasury bonds and corporate bonds fell to historically low levels, and dividend yields also fell.
The Fed’s actions this year have reversed those impacts. Bond yields are returning to pre-pandemic levels, and dividend yields are also inching up. We are still well below historical average levels, but a lot of pressure has been relieved.
Inflation and economic stagnation are certainly areas of concern for retirees, but it’s not all doom and gloom. From an income yield perspective, the Fed’s rate hikes are a major improvement. That’s good news for people who don’t have earned income.
Growth opportunities are back on the menu
Nobody wants to see big losses on their 401(k) statement, but it’s very important to recognize the difference between realized and unrealized returns. For long-term investors, last year’s losses are only temporary, and a 401(k) is a long-term account for most people under the age of 50.
In 20 or 30 years, this market correction will be a weak spot on the radar. Young investors shouldn’t panic and sell stocks today. Instead, it is better to continue accumulating assets and allocating them for growth. Growth stocks have taken a beating over the past year, enhancing the opportunity for long-term returns. The risk has been substantially reduced now that valuations are cheaper.
Think of this as a sale, where you can buy the exact same stock at a discount that wasn’t available 12 months ago. The Fed’s rate hikes have created a huge opportunity for some investors.