There has been a notable, upward adjustment in market interest rates of late, both here and in Europe, and that has led to some erratic behavior in stock markets both here and in Europe. Notwithstanding the spike in rates, it would be remiss not to add that market rates are still quite low historically speaking.
The issue for the stock markets wasn't so much that rates went up as it was the pace at which they increased. For instance, the yield on the German bund hit 0.05% in mid-April. On Thursday, it traded as high as 0.79% before buyers stepped in to stop the bleeding. The yield on the 10-yr Treasury note stood at 1.86% on April 1. On Thursday, it traded as high as 2.30% before drawing some support.
Why market rates went up in the rapid fashion that they did is open for debate. Various explanations have been provided, all of which are reasonable if not the specific trigger for the selling:
- The unwinding of a crowded trade
- Bill Gross and Jeffrey Gundlach, two of the most reputable bond fund managers around, suggesting the German bund is a terrific shorting opportunity
- The resurgence in oil prices fueling concerns about future inflation
- An expectation that stronger economic growth lies ahead
- The specter of rising policy rates in the U.S.
- A growing pack of smart-money investors, including Warren Buffett, suggesting bonds are very overvalued
- Technical support levels being violated; and
- Momentum trading cutting the other way
With all of the attention on rising interest rates, a journalist recently asked me if I wouldn't mind providing some insight that would help her write an article on investing in a rising interest rate environment. What follows below is what she asked and what I wrote (reprinted with her permission).
The Interview
Q: When do you see the Federal Reserve hiking rates?
A: Our current expectation is that the first hike in the fed funds rate will take place at the September FOMC meeting.
Q: What are the key economic factors to monitor that will determine when the Fed pulls the trigger on the first rate hike?
A: Well, the FOMC has seemingly provided the answer. In its most recent directive, it noted that, "In determining how long to maintain this target range [o to ¼ percent], the Committee will assess progress — both realized and expected — toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments."
Our sense of things, however, is that inflation indicators are the key factors to watch now. Look specifically at the trends in wage growth, PCE inflation, and core PCE inflation (excludes food and energy). With the unemployment rate at 5.4%, the Fed is sounding reasonably confident in its progress toward its objective of maximum employment. It's the other side of the mandate where confidence is lacking. Wage growth has been essentially flat since 2010, PCE inflation has dropped to just 0.3% year-over-year under the weight of falling energy prices, and core PCE inflation at 1.3% is still well below the Fed's inflation objective.
PCE inflation doesn't have to hit 2%. The Fed wants to be confident in sustained progress toward that objective. Since the Fed believes the oil price decline is transitory, the manner in which core PCE inflation moves could be a policy driver more than the Fed is willing to admit (note: I edited the unemployment rate to take into account the latest information found in the April employment report).
Q: What do stock investors need to be aware of in regards to the potential changing interest rate environment ahead?
A: Rising interest rates typically go hand-in-hand with an improving economy. That's a good thing. Stock investors, though, will need to be increasingly conscientious about how much they are willing to pay for each dollar of earnings in a rising interest rate environment. Higher rates eventually retard both economic and earnings growth. That won't happen instantaneously since a pickup in aggregate demand, driven by increased employment, wage growth, and capital investment, should presumably be the force driving higher interest rates.
A sticking point today, however, is that the S&P 500 is trading at roughly 17.5x forward twelve-month earnings, which is 10% above its 15-year average, according to S&P Capital IQ. Profit margins in turn are at record highs — and that's with market rates at historic lows and before policy rates have even been lifted. As market rates go up, share repurchase activity is apt to slow seeing how the low rates have provided some opportunistic financing of share buyback activity for many companies. The market can still deliver positive returns in a rising interest rate environment, but return expectations will probably need to be reined in from the double-digit returns seen in five of the last six years.
Q: Typically, what stock sectors are interest-rate sensitive and how/why can they benefit from a rising interest rate environment?
A: Cyclical sectors, like the industrial, financial, energy, consumer discretionary, and information technology sectors, perform more closely with the ebb and flow of economic cycles, unlike countercyclical sectors (eg. health care, utilities, consumer staples, and telecom services), which see relatively steady demand in any economic environment. Assuming interest rates are rising for the right reasons (i.e. stronger economic growth), cyclical sectors tend to do well in a rising interest rate environment on the presumption that stronger growth will invite better pricing power and stronger earnings growth.
Q: Any specific stocks that you see as having good potential?
A: Stretched valuations for many companies could limit returns when interest rates rise, but generally speaking, companies like Boeing (BA), Bank of America (BAC), Exxon Mobil (XOM), Nike (NKE), and Visa (V) are names that could be seen as having good potential in a strengthening economic environment. Cyclical sector ETFs include the Industrial Select Sector SPDR (XLI), the Financial Select Sector SPDR (XLF), the Energy Select Sector SPDR (XLE), the Consumer Discretionary Select Sector SPDR (XLY), and the Technology Select Sector SPDR (XLK).
Q: Are banks and financial companies poised to pull in more funds with higher interest rates? Describe how a rising interest rate environment could impact this sector?
A: Higher interest rates should benefit a variety of companies in the financial sector. Net interest margins and profitability should improve for banks as their lending rates and the interest rates on their investments (eg. Treasury securities) go up at a quicker pace than the rates they pay depositors. Insurers will have an ability to earn higher returns on the premium income they collect from policyholders. Asset managers, meanwhile, should attract more funds as investors seek better returns in higher-yielding assets compared to the relatively lower interest rates they will see for savings accounts and certificates of deposit.
Q: Specific stocks in this sector worth watching?
A: A whole range of stocks, including but not limited to the likes of Bank of America (BAC), US Bancorp (USB), Charles Schwab (SCHW), Chubb (CB), Allstate (ALL), MetLife (MET), BlackRock (BLK), T. Rowe Price (TROW), and Franklin Resources (BEN). Alternatively, one could also add exposure to the financial sector by way of the Financial Select Sector SPDR ETF (XLF) and/or the SPDR S&P Regional Banking ETF (KRE). (Disclosure: I have a position in the XLF and Briefing.com has a business relationship with Charles Schwab)
Q: Tell me about consumer discretionary stocks — how could they be impacted from a rising interest rate environment?
A: The early part of a rate hike cycle should be beneficial to the consumer discretionary sector since higher rates are presumably the result of a pickup in economic growth that is flowing from higher levels of employment (which creates a stronger sense of job security), higher wage growth, and increased lending activity that leads to higher levels of spending.
Job security is an important component, because employees who are confident they won't lose their job will be predisposed to spend more of their disposable income than they would if they were anxious about losing their job and finding another one. In turn, job security and a higher level of earnings promotes household formation, which invites a multiplier spending effect for new household needs.
The consumer discretionary sector is an expansive and diverse sector, encompassing auto makers, casinos, homebuilders, apparel retailers, specialty retailers, and cruise line companies to name a few. One way to increase exposure to the sector without taking on individual stock selection risk is by way of the Consumer Discretionary Select Sector SPDR ETF (XLY).
Q: Other stock sectors that could benefit from higher rates?
A: Nothing to add here from a sector standpoint versus what I have highlighted already. The payroll services companies, however, could benefit from higher interest rates. That includes companies like Paychex (PAYX) and Automatic Data Processing (ADP), which invest the funds they hold for clients in addition to other services they provide. Both stocks have already made quite a run though, so P/E ratios are looking stretched at this juncture. They are names to watch on pullbacks.
Q: Overall, do you have a "favorite" sector that could be poised to benefit from rising interest rates? If yes, what is it and why?
A: I like the financial sector. Rising interest rates are one more component that will help the sector achieve more normalized earnings growth. Many financial companies are quite profitable already even with increased regulatory burdens and litigation issues. They could be doing that much better if not for the very low interest rates that have compressed net interest margins.
The financial sector, through its capacity to lend, to insure, and to manage a growing base of assets, is in the sweet spot to benefit from a rising interest rate environment that is the product of stronger economic growth. As the sector's profitability increases, the prospect of increased capital returns through dividend increases and share repurchases should also improve, which should be attractive to current and future investors.
Q: Advice for investors when it comes to stock selection in a rising interest rate environment?
A: This is a unique time in history. Policy rates have been at the zero bound for more than six years and market rates are near historic lows. The stock market has benefited greatly from that condition, so it is reasonable to think volatility will increase as monetary policy reaches a long-awaited turning point.
Stock selection will ultimately be quite important seeing how stretched many valuations have gotten in a policy environment that has been geared toward driving buying interest in risk-based assets like stocks. Investors should look to own companies that can achieve quality earnings growth by way of solid revenue growth versus companies that struggle to increase revenue and engineer earnings growth by way of share buyback activity.
While much of the discussion has been oriented around which sectors could do well in a rising interest rate environment, it would be remiss not to add that the utilities sector, which tends to do well when interest rates are low, may be prone to underperform in a rising interest rate environment. In turn, emerging markets could be at risk if higher interest rates in the U.S. lead to capital flight from those markets.
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