Editor: Irfan Chaudhry
Contributors: Shafaq Kazi & Aliredha Walji
The Fed has cut interest rates three times this year due to weak economic data. These changes in interest rates affect the entire US economy. Understanding the relationship between interest rates and the asset performance can help investors understand how changes may affect their investments and how to make better financial decisions.
Fixed Income Market
’Fixed income instruments’ prices and interest rates generally have an inverse relationship, so a drop in rates leads to higher fixed income instrument prices and vice versa.
How does that translate to the Halal investing market space?
On the surface, they may seem like unrelated events, but falling interest rates directly affect the Sukuk market. The Sukuk market – especially US dollar denominated Sukuks – are benchmarked to the London Interbank Offered Rate (LIBOR), a floating interest rate charged by banks. A majority of interest rate products around the world are directly or indirectly linked to LIBOR. According to the Intercontinental Exchange (ICE), in 2018 there were over $350 trillion worth of debt instruments linked to LIBOR and Sukuk are among them. Therefore, falling LIBOR rates mean falling Sukuk rates. If you have cash holdings in your portfolio, such as Islamic money market instruments, falling rates may pull your portfolio returns below inflation return.
However, interest rate surprises tend to have a smaller impact on the returns and volatility of Islamic Sukuk than conventional bonds because Islamic bonds aka Sukuk are structured to avoid explicit interest rates.
You may learn more about Sukuk HERE
Another possible impact is the potential increase in new issuances in primary markets in a low oil price environment, which is supportive of all Sukuk prices. Longer duration Sukuks see a more immediate positive impact associated for falling rates. Also, in periods of uncertainty, when funds flee equities and other risky assets, fixed income instruments tend to become the safe haven asset of choice for that capital. The corporate Sukuk rate consists of the risk-free rate plus some spread. Falling interest rates may result in a decline in both the risk-free rate and spread to the risk-free rate, and hence a double whammy for driving prices higher.
The relationship between interest rates and the equity market is not as clear as it is with the fixed income market; however, it is nonetheless also an inverse one. Periods when the Feds are cutting interest rates tend to be bullish for equity markets, while a rising interest rate period tends to be bearish.
The stock market reacts to a change in rates in part due to changes in public sentiment. Cheaper credit helps investors to borrow at lower rates and invest it in stock market at a higher rate of return.
Further, as the risk-free rate goes down, the total return required for investing in stocks also decreases. Therefore, if the required risk premium decreases while the potential return remains the same or increases, investors may feel stocks are less risky and will put their money into the stock market.
Besides that, cheaper credit also positively affects earnings and hence stock prices. Cyclical sectors benefit most from an interest rate decline. Particular winners of lower rates are dividend-paying sectors such as utilities and real estate investment trusts (REITs). Additionally, large companies with stable cash flows and strong balance sheets benefit from cheaper debt financing. On the other hand, the banking sector can be affected negatively by decline in interest rates because of repricing of loans and mismatch in assets and liability duration.
However, if expectations differ significantly from the Fed’s actions, these generalized, conventional reactions may not apply. And there is no guarantee how the market will react to any given interest rate change the Fed chooses to make. Further, the effect is temporary as fundamental and economic factors take over pretty quickly.
Real Estate Market
Probably the biggest impact of interest rates is felt in the real estate market. The prime interest rate which forms the basis for mortgage loans, is largely based on the federal funds rate. Whether it is a residential mortgage or a commercial loan for an industrial property, the interest rate will dictate the affordability and viability of that real estate.
Falling rates can make home-buying affordable for certain borrowers, despite a general decline in affordability. At the same time, falling rates may not be beneficial for rental property owners, who may have to cut rent if rental demand falls as ownership increases.
The Bottom Line
When consumers spend more it can directly impact corporate bottom lines. Increasing revenues and profit growth can in turn affect a company stock’s and Sukuk’s performance positively. Interest rates have a massive impact on the whole economy – including investments – and influencing the rate is one of the strongest tools at the disposal of a Central Bank.
How does this all play into one’s investment strategy?
The answer to how you should be investing when interest rates fall is fairly simple: you should invest the same way you should always be investing. That means building a diversified portfolio made up of quality stocks, sukuks, cash and Islamic money market instruments that will pay you income through the ups and downs of the markets and the global economy.
Trying to time the market or predict which way rates will go is a wasted effort in the long term. The smartest thing investors can do is mindfully manage their portfolios to limit the downside and increase potential upside as interest rates and the market fluctuate.
Diversification is the best way to do that—regardless of where rates are.
While fixed income securities and derivative investments are off limits under the guidelines of Sharia-compliant investing, there are many ways to diversify while also complying with Sharia. If you’re interested in building a Sharia-compliant portfolio, consider working with Sharia-compliant investment professionals such as the ShariaPortfolio team who can customize your portfolio to your specific needs.
For more information please call us at (321) 275-5125 or send us an email at email@example.com.
Investing in securities involves risk, and there is always the potential of losing money when you invest in securities.
Halal compliant investments, diversification and asset allocation do not ensure a profit or protect against loss.
This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.