January 18, 2005

Investing When Rates Rise: The Case for Caution

Jan. 12, 2005 -- With the Federal Reserve expected to continue tightening interest rates, where should investors turn?

Since interest rate hikes generally signal excess demand, gold, precious metals, and Treasury Inflation Protected Securities (TIPS) are likely to hold up better, said John Krey, senior investment officer in Standard & Poor's Portfolio Advisors.

Gold and other precious metals can offer stability with a falling dollar and continued geopolitical instability. Despite the recent sell-off, natural resource investments, including copper and platinum, also are likely to hold up due to firm commodity prices that stem from still healthy worldwide economic growth.

In addition to TIPS, investors should hold some cash, Krey said. Rising rates means better returns for savings and money-market accounts. At present, Standard & Poor's Investment Policy Committee (IPC) recommends a 15% cash stake in its recommended asset allocation.

Overall, the current interest rate environment offers few promising investments since "it's hard to get clarity about the current cycle," said Krey. The Fed usually raises rates when inflation looms, and as the economic recovery matures. Compared to previous periods of rising rates, high inflation currently appears less imminent.

Despite the lack of clarity, U.S. stocks are likely to underperform as rates rise. During previous rate tightening periods, "very few U.S. equities did well," said Sam Stovall, Standard & Poor's chief investment strategist. In the last six periods when the Fed raised rates more than once, the U.S. stock market fell four times, he noted.

When it comes to precious metals, there are a handful of gold/metals mutual funds, but experts generally recommend a small allocation, typically not more than 5%. Standard & Poor's currently ranks both First Eagle Gold Fund (SGGDX) and Evergreen Precious Metals/A (EKWAX) 4 Stars. A gold ETF, streetTRACKS Gold Shares (GLD), was recently launched in November, but is too new to be ranked by Standard & Poor's.

Mutual funds that focus on TIPS, include Vanguard Inflation Protected Securities (VIPSX), ranked 5 Stars, and Fidelity Inflation-Protected Bond (FINPX). In addition, there is iShares Lehman TIPS Bond Fund (TIP) an ETF offering. Both the Fidelity and iShares Lehman funds are too new to be ranked. For a further explanation on TIPS funds, please see 'Looking For Hot Bond TIPS?'

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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