Over the past decade or so, interest rates have been front and center when it comes to what investors, analysts, and economists pay the most attention to. It's not really surprising: Interest rates underpin everything that happens throughout the economy, affecting consumers and businesses immensely.
From an investment perspective, that might be discouraging, because we have zero control over interest rates. But it's not all bad news. What you do have control over is what you do with your portfolio, and this can help you navigate the uncertainty.
The power of the Federal Reserve
The Federal Reserve is the central bank of the U.S., and it's tasked with a dual mandate: Maintaining "full employment" while at the same time keeping inflation relatively calm. Those two goals can and do conflict with each other. One tool the central bank's leaders use to perform these duties is setting the federal funds rate, a key interest rate at which commercial banks lend money to each other in overnight markets.
I don't know if there's ever been a time in history when the Fed's actions were as closely watched as they have been during the past 18 or so months. Due to inflation surging to levels not seen in the U.S. in decades, the central bank in March 2022 embarked on a rapid series of interest rate hikes. The goal was to get inflation back to the Fed's target in the neighborhood of 2%. But the last time the fed funds rate was this high was about 16 years ago, so many investors aren't familiar with how the economy and market should behave in this type of environment.
Higher interest rates can be a drag on stock prices. Higher rates act to pump the brakes on the economy, which can lead to curtailed capital expenditures, pressured consumer spending, corporate layoffs, and slower revenue and earnings growth. But all of these things act to dial back demand, which tends to weigh on prices, thus bringing down inflation. This is why anything the central bank says or does is so scrutinized.
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Ignore the macro
All of this might lead investors to want to base their actions on their predictions about what the Fed will do to interest rates next. If rates are likely to keep rising, then you may think it's best to stay on the sidelines for now and wait to buy stocks.
However, it's not that easy. Howard Marks, arguably the best credit investor and macro thinker out there, wrote in a 2021 memo that his firm doesn't make investing decisions based on macro forecasts. Moreover, he mentioned that "Oaktree and I approach macro forecasts with a high degree of skepticism."
Warren Buffett's perspective is similar. During Berkshire Hathaway's 1997 shareholder meeting, he said that macro factors play no role in his investment process.
Focus on the fundamentals
At the end of the day, investing is about picking great businesses that can perform well over long periods, no matter what the interest rate environment is. That last part is critical. Many fast-growth companies, dependent on debt to fuel that growth, are now struggling to stay afloat as their borrowing costs have risen. These are the kinds of investments you want to avoid.
Instead, focus on the most financially sound businesses. Apple is the perfect example. It has more than $50 billion of net cash on its balance sheet. And in fiscal 2022, it generated a ridiculous $111 billion of free cash flow. There's virtually no risk that Apple will run into financial trouble anytime soon.
But don't rush to buy shares just yet. I've argued before how I think Apple stock looks overvalued due to its above-average price-to-earnings ratio of 28.6. Nonetheless, this is still a great lesson for investors. If you find yourself constantly worried about what the Fed's next move will be and how it will impact a stock in your portfolio, then that's probably not a good stock to own.
