Following another strong jobs report, the Federal Reserve is widely expected to drop the word "patient" from its monetary policy statement next Wednesday, signaling that a rate hike is likely coming soon. Whether it happens in June or September, higher interest rates appear to be finally coming.
Be prepared before that happens. Because by the time our
central bank officially announces it is raising rates, many stocks will
already have the move priced in.
There will be clear winners and losers during a rising interest rate
environment. Investors looking to profit from a rate hike, or simply
avoid significant underperformance, should consider shifting their
Rate Hike Losers
The Fed has stated if the economy continues to improve, rates will rise.
After a stellar February jobs report blew away expectations, it's
looking very likely that rates could rise sooner rather than later.
It's well known that a rising interest rate environment is bad for bonds
overall, as their prices move opposite of rates. This is especially
true for long duration, low coupon bonds. However, the impact on stocks
will be much more mixed.
Some areas of the market are likely to suffer. Here are the areas I would avoid:
• High Yielders: As interest rates march higher,
dividend yields will look comparatively less attractive to income
investors than the yields on fixed income and money market accounts.
Areas like real estate investment trusts (REITs) and utilities meet
these criteria, as do Master Limited Partnerships (MLPs) and some stodgy
consumers staples. The "reach for yield" trade that drove the
valuations of many of these high yielders to record levels is likely
coming to an end soon.
• Highly Leveraged Firms: Companies with highly
leveraged balance sheets that rely heavily on debt financing are likely
to underperform too. That's especially true for firms who are constantly
issuing short-term debt to meet their obligations. Higher interest
rates means higher interest expenses for these firms, and less profits.
Once again, both real estate investment trusts (REITs) and utilities
generally fit this description. It should come as no surprise that both
areas significantly underperformed the S&P 500 during the second
half of 2013 as long-term rates rose amid taper talks.
• Exporters: While our central bank is looking to raise
interest rates, much of the rest of the world is trying to lower
theirs. This could very likely lead to continued strength in the U.S.
dollar, which would make our goods comparatively more expensive
overseas. That would create a headwind for large multinational firms
that derive a majority of their revenue from outside of the United
Rate Hike Winners
However, there are some industries that are clamoring for higher interest rates:
• Insurers: One particular beneficiary of higher rates
is the insurance industry. Insurance companies take in premiums from
customers, invest them - usually in fixed income securities like bonds -
and then pay out claims in the future. Much of their profits are made
on the interest income from their investments. When rates rise, they
will be able to earn more interest from their investments. While it's
true the value of their existing bond holdings would decline when rates
rise, insurers with a relatively short duration on their investment
portfolios should be relatively immune.
• Brokers: Other companies anxiously waiting for rates
to rise are brokerage firms. Brokerages earn interest income on
un-invested cash in customer accounts. So when rates rise, they can
invest this cash at higher rates. While they will have to pay more
interest on those cash balances, the spread between what they earn and
what they pay out should widen from where it is today.
• Banks: Banks could also benefit from rising interest rates, as long as long-term rates move up more than short-term rates.
Think about a bank's business model: they pay interest on deposits and
loan that money out at higher rates. The interest rates on deposits are
typically tied to short-term rates while loans are often tied to
long-term rates. In other words, banks benefit from a steep yield curve,
meaning when the spread between long-term and short-term rates is wide.
So if the Fed hikes short-term rates, but long-term rates like the
10-year stay put, this will actually hurt net interest margins.
However, keep in mind that if the Fed raises rates, it will be because
the economy is improving and inflation expectations are rising. Both of
these conditions typically drive up long-term interest rates too, likely
by more than the Fed raises short-term rates (usually in 25 basis point
increments). Also, an improving economy means that credit quality is
likely improving, which is great for banks' bottom lines as well.
Small cap banks should benefit the most from a steeper yield curve since
a larger chunk of their profits come from interest income than large
cap banks, which usually have more diversified revenue streams and are
less susceptible to the yield curve.
The Bottom Line
If the U.S. economy continues to improve, then expect the Federal
Reserve to finally increase interest rates from their rock-bottom levels
relatively soon. Be prepared for the rate hike by shifting your
portfolio now before it gets fully priced in. While some areas of the
stock market are likely to underperform, others are well-positioned to
profit. You should be too.
-- Todd Bunton, Weekend Wisdom