Bracing For Higher Interest Rates

6/1/2015


The tailwind of low interest rates has filled stocks' sails for more than six years. And it's just a matter of time before interest rates creep higher.

Historically, the Fed has relied on low interest rates as a temporary crutch until a struggling economy could move forward under its own power. Today, pockets of the U.S. economy still feel the lingering effects of the crippling Great Recession, which officially lasted from December 2007 to June 2009, according to the National Bureau of Economic Research. The federal funds rate, viewed as the benchmark for short-term rates, has idled near zero since December 2008.

Stocks usually perform better when rates are falling, as mentioned in the March 2 issue. Periods of low or falling interest rates can create a dearth of options for a decent fixed-income return, pushing more investors into stocks. Conversely, stocks tend to underperform when rates are rising, particularly in environments of lower growth and higher inflation.

We tracked how the 10 sectors in the Dow Jones U.S. Index fared in periods of rising interest rates over the past 25 years (see the table below). No sector outperformed in all three of the periods we considered. Energy and health-care stocks topped the broader index in each of the two most recent periods and also performed fairly well in the earliest period, from December 1993 to April 1995.

RISING INTEREST RATES NOT ALWAYS BAD FOR STOCKS
Sector returns reflect the average stock in the Dow Jones U.S. Index from the month when interest rates bottomed through the month when rates peaked. While sector performance varied, the broad index rose in all three periods.
Sector Returns When Interest Rates Rise
Dec. 1993
To April 1995
(%)
June 1999
To July 2000
(%)
Dec. 2003
To July 2007
(%)
Consumer Goods
(0.5)
(19.3)
24.0
Consumer Services
(2.7)
(14.1)
28.2
Energy
10.5
33.7
149.2
Financial
14.8
(2.7)
34.2
Health Care
6.9
56.6
46.6
Industrials
18.2
4.7
60.9
Materials
17.9
(14.0)
71.7
Technology
47.5
83.8
15.1
Telecommunications
1.1
(1.9)
86.6
Utilities
(1.6)
7.1
50.1
Dow Jones U.S. Index
11.7
9.5
43.0

Here are some possible sector- and industry-related trends to watch:

• Many investors have treated utility, consumer-staples, and telecommunication stocks as bond proxies; these stocks could be vulnerable to a sell-off when income-thirsty investors move back into bonds.

• Banks appear favorably positioned for a rate hike, as increasing net interest margin should offset lower mortgage revenue.

• Materials stocks, which rely heavily on commodity prices, could benefit from higher inflation.

• A rate increase could depress sales of items consumers borrow to purchase, such as cars and homes — bad for construction and auto-related stocks.

The Fed is plotting a cautious course and seems to have telegraphed its intentions fairly well. U.S. central bankers say they'll begin to move rates higher when they see three things:

1) Healthy economic growth.
2) Low unemployment.
3) Inflation near 2%.

Still, the timing of a rate hike remains unclear. At the beginning of the year, many Fed officials had anticipated raising the federal funds rate by the middle of 2015. But based on the minutes of a late-April meeting, most seem doubtful that conditions will allow for a rate increase at the next meeting in mid-June. Fed Chairwoman Janet Yellen said the central bank expects to raise rates this year "if the economy continues to improve as I expect." The median analyst surveyed by Reuters earlier this month projected a rate hike in the third quarter, a view Yellen's comments did nothing to undermine.

Inflation continues to plod along below 2%. The U.S. economy grew at an estimated annual rate of just 0.2% in the first quarter. Blame the sluggish growth partly on temporary factors — including harsh weather and a labor dispute at shipping ports on the West Coast — though disappointing industrial production and retail sales could signal bigger problems ahead. There is a bright spot — the U.S. unemployment rate, which fell to 5.4% in April from 5.6% in December and the Great Recession's peak of 10.0% in 2009.

Two of the past nine rate-hike cycles since 1963 closely resemble today's environment, with a strong U.S. dollar and rising oil prices, says J.P. Morgan. In both periods, 1976 and 1999, stocks were unusually weak and P/E ratios contracted more than usual in the six months leading up to the rate hike and the six months that followed. This time around, the Fed might increase interest rates at a more gradual pace than in past periods and let rates peak at a lower-than-normal level, for fear of triggering another recession.

Remember, monetary policy is but one factor affecting the stock market. Company fundamentals ultimately drive most stocks' performance. An economy the Fed views as sturdy enough to withstand higher interest rates should benefit U.S. companies.


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