Markets are near all-time highs and there are plenty of reasons for optimism in 2021. Vaccines, the economic reopening, and pent-up demand are a few of the big ones.
Corporate cost efficiencies are another: The pandemic forced companies to find more efficient ways to operate. All else being equal, when businesses lower their expenses, their earnings increase. This should be a positive for fundamentals moving forward.
But one of the most important drivers of the stock and bond markets right now is the low interest rate environment.
Low rates tend to benefit the stock market in two ways
- When businesses can borrow at attractive rates they can expand operations, hire workers, and increase investment. This increases economic activity, ultimately leading to more dollars in the pockets of consumers, which tends to be a tailwind for stocks and the underlying businesses.
- A low interest rate environment reduces investment options for investors who are focused on return. When a savings account at the bank yields next to nothing, investors may look to other asset classes like stocks to make money.
The bond market is a different story
In a low interest rate environment, not only are the rates a bond pays to investors lower, but the value of the bond can be negatively affected by a rise in interest rates. When interest rates increase, the value of the bond holdings tend to fall (If you own a bond that pays you a 2% interest rate annually, and interest rates rise to 4%, there's a lot less demand for your bond).
With interest rates near historic lows, mean reversion would tell us that rates should move up in the future, its only a matter of when (Caveat: Interest rate movements are VERY hard to predict).
The takeaway
Determine which objective you want to achieve within your portfolio. If it's growth/return, consider overweighting to stocks which involves taking on more risk. If its protection/capital preservation, the former might not be an option. You'll likely need to lower your return expectations for the bond portion of your portfolio compared to previous years. Otherwise, depending on your situation, you may need to make other financial adjustments that will keep you on track to reach your retirement goals.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. No strategy assures success or protects against loss. Investing involves risk including loss of principal.