Turn to the financial news, and it seems like the main topic of discussion is what's happening with interest rates. This makes sense, given how important they are to the global economy. And there are a lot of implications not only from a consumer perspective, but also when it comes to properly allocating a portfolio.
To be clear, investors have zero control over what happens with interest rates. However, they do have full power over what to do about them. Let's take a closer look.
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All eyes on the Fed
Interest rates across the economy are influenced by the Federal Reserve's federal funds rate, which is the rate that banks lend to each other in overnight markets. The central bank adjusts this rate to help set monetary policy. For example, when the economy hits a rough patch, unemployment is high, or inflation might need a boost, the Fed will lower the rate to spur lending and borrowing activity.
On the other hand, when the economy is on strong footing, unemployment is low, and inflation might be elevated, rates are increased. The fed funds rate influences other rates that banks set for different products they offer.
That latter scenario of tightening is what the U.S. has been experiencing since early 2022. In March of last year, the Federal Reserve started on its path of raising interest rates at the fastest pace in history, with the primary goal being to curb soaring inflation. And this cycle isn't over, as there's the possibility of another rate hike before the year ends. That's because inflation is still running above the Fed's 2% target.
This is all critical because it's hard to deny how important the central bank has become to equity markets in the past decade. Rising rates are generally bad for stocks because they indicate tighter monetary policy with the potential that the economy could slow down, which could hurt the sales and profits of companies. And this could negatively impact their share prices.
The attention that the Federal Reserve gets is unbelievable. Any changes with commentary or verbiage makes headline news these days.
Own financially sound companies
Investors who care about the long term (at least five to 10 years out) when making portfolio decisions can avoid trying to predict what happens with interest rates and play a different game altogether.
I think the best course of action is to understand and accept that no one has any clue what direction interest rates are going in, not even the central bankers. Moreover, it's clear that the U.S. is in a rate environment that we haven't been in since before the subprime mortgage crisis.
From an investment perspective, this leads me to believe that investors should prioritize owning sound financial companies over more speculative names that might depend on favorable capital market conditions for their success. Look for businesses that have strong balance sheets, manageable debt burdens, consistent profitability, and the ability to generate lots of free cash flow (FCF).
Not only will this give you peace of mind with your portfolio, with the knowledge that these companies aren't at any risk of running into financial troubles, but it makes trying to forecast the direction of interest rates completely unnecessary. These businesses should still be on solid footing no matter what happens with monetary policy.
A company that fits this description is Apple. As of July 1, it had $167 billion of cash, cash equivalents, and marketable securities on its balance sheet versus $109 billion of debt. And thanks to its customer loyalty and pricing power, the business is incredibly profitable, generating a gross margin of 44% and an operating margin of 28% in the latest fiscal quarter. Plus, Apple generates tons of FCF.
It's also a valid argument that at a trailing price-to-earnings ratio of 29, the stock is expensive today. However, I don't think anyone would disagree with the fact that whatever happens with interest rates has almost no impact on Apple's success, at least when compared to pretty much every other company.
