The stock market dropped this week after the August Consumer Price Index indicated that inflation was higher than expected. Paired with a decent employment report, this inflation data opened the door to continued rate hikes by the Federal Reserve. Rising rates are going to have a handful of important impacts on different asset classes, and investors need to understand how those all fit together in a retirement plan.
Your 401(k) will drop in the short term
Rate hikes are wreaking havoc in the stock market.
It's not always a perfect relationship, but the stock market tends to move in the opposite direction as interest rates. When recessions strike and unemployment spikes higher, the Fed usually slashes interest rates. That boosts economic growth and encourages investor risk appetite, which sends stocks higher.
Inflation usually rises if expansionary conditions persist for long enough. Tight labor markets drive wages higher, and strong consumer sentiment gives pricing power to businesses. To combat inflation, the Fed raises interest rates. When the cost to borrow money increases, businesses pull back on hiring, the housing sector slows down, and consumer spending drops. These all signal investors to reduce portfolio risk, and stocks usually tumble.
If you've watched the market over since the pandemic started, then you've witnessed all of this play out in real life. A sudden drop in economic activity prompted aggressive action from central banks, which flooded economies around the globe with cash. This supported business activity and employment, and it fueled an 18-month bull market.
Low interest rates and high employment combined with other factors to drive exceptionally high inflation as we moved into 2022. Consumer prices outpaced wages, which became a threat to economic stability, and it forced the Fed to raise rates. As expected, the stock market responded with high volatility and losses in all of the major indexes. Growth stocks have sustained 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's impossible to tell if we've hit a bottom yet. There's a chance that all future hikes are already priced into stock valuations, and that the next Fed announcements won't cause any more damage. However, any indication that monetary tightening will exceed expectations is almost certain to push stocks lower. Slow economic growth is likely to be an additional drag on stocks over the next few quarters.
Investors need to prepare for more volatility in their retirement accounts. Don't sell stocks that are temporarily down unless you have to. If you have more than 15 years left until retirement, it's still appropriate to invest for growth. If you're approaching retirement, make sure that you've established the proper allocation of bonds and other low-volatilty assets.
Income yields are going up
The stock sell-off will sting for retirees, but there's a major silver lining: higher rates on savings and fixed-income investments. That's a reversal from the rock-bottom rates over the past decade, which created a serious challenge for retirement planning.
For much of the 2010s, bonds didn't kick off as much interest as they used to, and the rates on savings accounts and CDs were low, along with the average dividend yield in major stock indexes. Retirees needed to have more assets amassed in order to generate the same amount of investment income. The issue was so acute that many financial advisors are calling for the 4% Rule to be revised downward.
This problem only got worse in the aftermath of COVID-19. Interest rates on Treasuries and corporate bonds dropped to historically low levels, and dividend yields also dropped.
The Fed's actions this year have reversed those impacts. Bond yields are moving back toward pre-pandemic levels, and dividend yields are inching that way as well. We're still way below historically 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 from working.
Growth opportunities are back on the menu
Nobody wants to see big losses on their 401(k) statement, but it's really important to recognize the difference between realized and unrealized returns. For long-term investors, the losses of the past year are only temporary, and a 401(k) is a long-term account for the majority of people under 50 years old.
Twenty or 30 years from now, this market correction will be a blip on the radar. Young investors shouldn't panic and sell stocks today. Instead, it's best to continue accumulating assets and allocating them for growth. Growth stocks have taken a beating over the past year, which has improved the opportunity for long-term returns. The risk has been reduced substantially now that valuations are cheaper.
Think about this as a sale, where the exact same stocks can be purchased at a discount that wasn't available 12 months ago. The Fed's rate hikes have created an exciting opportunity for some investors.