The last couple of years have been interesting from a macroeconomic perspective. Following a surge in consumer demand after the worst days of the pandemic, coupled with supply chain bottlenecks, the U.S. started experiencing inflation not seen in decades toward the second half of 2021.
Consequently, the Federal Reserve embarked on its most aggressive rate-hiking path ever starting in March 2022. The goal was to curb these inflationary pressures. Based on the latest Consumer Price Index (CPI) data, things are heading in the right direction.
The encouraging trend has resulted in the Fed signaling that it will cut interest rates multiple times this year, a scenario the market already seems to be excited about. That's evidenced by the S&P 500 index and Nasdaq Composite Index rising 9.7% and 9.4%, respectively, this year (as of March 25), following huge gains in 2023.
But what if the central bank doesn't end up lowering interest rates this year? If that happens, here's how you can protect your portfolio.
Understanding investor expectations
The stock market is a forward-looking system. Investors buy and sell stocks based on what they believe will happen in the future. Lowering rates is viewed as stimulative behavior by the Fed, meant to spur lending, borrowing, and spending. Moreover, seeking higher yields and returns, investors favor riskier assets.
Therefore, it makes sense why stocks have soared so far this year. The bull run that both the S&P 500 and Nasdaq Composite Index are currently on might indicate that investors are already pricing in looser monetary policy later this year. Again, it's all about what investors are expecting will happen.
The Fed explicitly targets a 2% long-run inflation rate. The latest CPI print from February showed a 3.2% year-over-year rise. That's down significantly from 9% at the recent peak in June 2022. Surely, many analysts and economists see a clear path to 2%.
Let's assume, however, that inflation doesn't get to that level. What if it stubbornly stays above 3% instead?
In this scenario, the central bank probably won't lower rates, unless it wants to risk inflation accelerating. And perhaps the Fed even raises rates to bring inflation down to its goal. Stocks would likely take a hit because this is not what investors are anticipating. It would be a negative catalyst.
Image source: Getty Images.
Focus on these types of businesses
To be clear, trying to predict what will happen with the economy is a losing game. Inflation could pick up steam, stay in its current range, or drop like the Fed wants. But no matter how smart someone sounds, no one knows what the future holds.
Just look at the Federal Reserve, a group of the most accomplished and well-educated economists on Earth. Even they didn't see surging inflation coming. And when it was here, they first believed that it was a temporary phenomenon.
For the individual investor, the best course of action is to try to identify durable businesses that can perform well in all types of economic situations. This means owning recession-resilient companies.
AutoZone and O'Reilly Automotive immediately come to mind. They're dominant aftermarket auto parts retailers that benefit from durable consumer demand in good and bad times. People need functioning vehicles, leading revenue and earnings to steadily rise for these enterprises.
The key is to try to find companies that would experience strong demand no matter what's happening with interest rates. This doesn't necessarily mean that their share prices won't be negatively impacted. But you can have peace of mind knowing that such companies should report solid financial results nonetheless.
Investors should spend much less time worrying about macro issues and much more time focused on which individual businesses are recession-resilient.
