How Interest Rates Impact Alternative Investments

Masterworks
November 17, 2021

Did you know that 87% of investors plan to maintain or increase their allocation of alternative investments over the next 12 months? After all, with the nail-biting roller coaster that was the stock market in 2020, more and more investors are interested in investing beyond the traditional stocks and bonds to ensure that they have a healthy portfolio.

But with interest rates rising, it’s time to start thinking of alternative investments as more than just a safety net. You have to think about how they perform on the market as a whole—especially when the market is facing tough weather.

Here’s a look at interest rates, alternative investments, how alternative investments perform when interest rates rise and fall, and how to think about alternatives in the larger investment context.

The Basics of Alternative Investments

An alternative investment is anything that doesn’t fall into one of the three conventional investment categories:

  1. Stocks
  2. Bonds
  3. Cash

In other words, anything that isn’t a stock, bond, or cash technically qualifies as an alternative investment. This means alternative investments include a huge variety of assets, such as:

  • Fine art
  • Antiquities
  • Precious metals
  • Hedge funds
  • Real estate
  • Venture capital
  • Private equity
  • Distressed securities

And while comparisons among such investments might end up sounding like comparing a raven and a writing desk, alternative investments generally have a few characteristics in common:

  • Low correlation to traditional investments
  • Relatively low liquidity
  • High purchasing costs
  • Difficulty in determining underlying value

In other words, alternative investments are much more complex than their conventional cousins, and they can’t be expected to perform on the market like a stock or bond.

The Basics of Interest Rates

This brings us to interest rates, one of the key drivers of the investment market and a critical policy tool.

The United States Federal Reserve (known commonly as the Fed), which sets fiscal policy for the U.S. markets as a whole, has three major areas of concern: inflation, unemployment, and interest rates. It uses interest rates as a financial policy tool to help mitigate trends in inflation and unemployment.

Basically, the Fed sets interest rates (technically just the federal funds rate, which influences all other interest rates) in an effort to maintain maximum sustainable employment, low and stable inflation, and moderate long-term interest rates. Taken together, this creates the best possible economic environment for American households. Interest rates influence spending decisions, in that lower rates would encourage consumers and businesses to lend and borrow money, while higher interest rates can restrict such activity.

For example, during economic downturns, the Fed may drop the federal funds rate to its lowest bound (near zero). This makes it cheaper to borrow money, which can encourage consumers to spend money and (hopefully) get the economy back on its feet. Conversely, if the Fed finds that the economy is growing unsustainably, it may raise interest rates to tap the brakes, so to speak, and keep the economy on an even keel by slowing the growth of inflation.

How Interest Rates Affect Investments

This has complicated impacts on the market as a whole and huge implications for investors.

Basically, the Fed is trying to make decisions for the good of the whole economy, which may sometimes have uncomfortable short-term implications for investors and companies. Interest rates change the cost of borrowing—so, in a simple example, higher interest rates make it more expensive to borrow money, while lower interest rates make it cheaper. On the other hand, rising interest rates also mean saving money is more profitable, which is exactly what the Fed wants consumers to do when it raises the federal funds rate.

However, these apparently simple mechanics have a tricky relationship to the investment market and an even trickier relationship with alternative investments.

Stocks and Bonds

For example, interest rates and bonds have an inverse relationship: when interest rates go down, bond prices go up and vice versa. This is because of three concepts:

  1. Short-term changes vs. long-term outlooks
  2. Fluctuating interest rates and fluctuating market rates
  3. Paper yields and paper losses

Let’s say you purchase a bond for $1,000, and let’s say the Fed then increases interest rates. Your market value may decrease to $900, but this may only be a paper loss, since you may still receive the full value of the bond if you hold it to maturity. However, shorter maturity bonds are less affected by interest fluctuations than longer maturity bonds. Either way, you have to remember that short-term interest changes do not implicitly translate to your long-term outlook.

As for stocks, they’re a bit trickier.

Basically, interest rates do not directly affect the stock market, but they can have important trickle-down effects. Let’s say the Fed lowers interest rates. Since it’s cheaper to borrow, banks may lower their rates for consumer loans, which means there’s more money for consumer spending and more money for businesses, which can mean businesses increase spending and hiring. That would raise the stock value. However, none of this relationship is guaranteed—it depends on the company and the market conditions.

Interest Rates, Alternative Investments, and the Market

So, where does that leave alternative investments? In short, it’s complicated.

In simple terms, you’re most likely to see rising interest rates going into a bull market (when the economy is stronger). Generally, with a good stock/bond balance, you’re well-positioned to maintain stability.

However, keep in mind that alternative investments have very low stock market correlation. What’s more important for alternative investments is how interest rates affect consumer confidence. While rising interest often happens while the market is strong, they’re also a warning sign that may make investors antsy.

What this means depends on the alternative investment in question. All alternatives operate in niche markets, and how much consumers are willing to spend on them depends on a) their willingness to buy certain assets in certain market conditions, b) their confidence in the asset in question, and c) how they intend to use that asset. Fine art, for example, has long been used as a stock market hedge against inflation, and can sometimes double as a rescue asset like gold.

Your Partner in Successful Alternative Investing

If you take nothing else away from interest rates and alternative investments, remember this: it pays to have an expert in your corner.

Here at Masterworks, we act as your expert partner in the art world. We handle research with Citi Bank and Bank of America to identify high-value artist markets with the highest potential risk-adjusted returns, then validate art in those markets so that our members can purchase shares in the art and collect dividends when we make a sale. That way, you can benefit from the market hedge of blue-chip art investing without the headache of staying ahead of the market. Sound good? Then fill out your membership application today to learn more.


Masterworks
Masterworks is a fintech company democratizing the art market. Our investors are able to fractionally invest in $1mn+ works of art by some of the world's most famous and sought-after artists.