Banks will benefit from rising rates. Other sectors, not so much

  • By Avi Salzman,
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Interest rates are finally on the rise again, and investors are reeling. In the past three weeks, the yield on a 10-year Treasury note has jumped from 2.99% to 3.23%, the highest level since 2011. A yield of 3.23% ordinarily wouldn’t turn heads—it’s below historical norms—but a decade of ultralow rates following the financial crisis has made the market acutely sensitive to such a shift.

A spike in yields on Wednesday coincided with the Dow Jones industrials’ (.DJI) loss of 832 points, the index’s largest drop since February. After a selloff like that, which contributed to the Dow’s 4.2% decline on the week, some investors might be tempted to curl up into a ball. But there are ways to take advantage of rising interest rates, market strategists say.

“Some areas of the market that look inexpensive—financials, enterprise tech, industrials—actually would benefit from rising interest rates,” contends Savita Subramanian, U.S. equity and quantitative strategist at Bank of America Merrill Lynch. “Utilities, food stocks, and staples are looking relatively expensive, and are much more hurt than helped by a rising interest-rate environment.”

Subramanian sees the market’s rout as an opportunity to buy some of the more-beaten-down cyclical names. These stocks could perform well in a rising-rate environment, she says, because the companies’ growth prospects are improving.

Higher yields tend to spook the market because they mean higher borrowing tabs for businesses and consumers. That means they’re less likely to take out loans and spend more. The average rate for a non-jumbo 30-year mortgage topped 5% last week for the first time since 2011, according to the Mortgage Bankers Association—and home-loan applications fell. Higher rates make it riskier for corporations to take on debt, and make defaults more likely.

Still, higher rates alone don’t spell doom for stocks. Rates tend to climb when the economy is humming, which generally is good news for the markets. SunTrust examined 15 periods of rising rates over the past 65 years and found that stocks gained an average of 12.6% during those stretches on an annualized basis, falling only three times. A Bank of America analysis found that companies’ price/earnings multiples expanded during half of the recent rising rate cycles and contracted during the other half, indicating that the market is agnostic about changes in rates.

Rising interest rates tend to be destructive under only a few circumstances. When Treasury yields move up gradually, the stock market tends to rise, too. But when yields increase by more than 12 basis points (0.12 of a percentage point) in a day, stocks tend to fall, according to Credit Suisse .

“If rates rise very rapidly or precipitously, the market sees that as disruptive,” says Jonathan Golub, chief U.S. equity strategist at Credit Suisse, noting that sudden spikes can come from unexpected actions by the Federal Reserve, or other “exogenous shocks.”

The latest rise in rates was sparked in part by comments from Fed Chairman Jerome Powell, who said this month that the federal-funds rate, now at 2% to 2.25%, is still “a long way” from neutral, or the level at which the economy is in balance. Powell’s remark suggests that the central bank is likely to continue hiking rates. It registered as controversial only because they’ve been so low for so long. In fact, Fed rate hikes since 2015 have been unusually slow by historical standards. Based on today’s inflation rate, fed funds ought to be closer to 3.5%, according to CFRA chief investment strategist Sam Stovall.

Sudden shocks aren’t the only danger. Higher rates also become destructive above a point at which they start threatening to detract from economic growth. In the past, the magic number was 5%, Golub says. But with the economy growing more gradually these days, the break point is probably closer to 3.5%, he estimates.

Interest rates also can sting when short-term rates are higher than long-term ones. An “inversion” in the yield curve—which occurs when long-term debt yields less than short-term obligations—tends to signal a coming recession. An inversion came close to materializing in August, but the recent rise in long-term rates has made one less likely.

Rising rates affect various assets in different ways. They historically have hurt bonds, whose prices fall when yields head north. Stocks that trade like bonds, including utilities and some real-estate stocks, also are sensitive to higher rates. Banks, however, benefit from increases in rates, which allow them to make more money on loans and other products. Cyclical stocks generally do better than defensive issues in a rising-rate environment, which tends to coincide with an expanding economy.

Here’s a closer look at the impact of higher interest rates on market sectors.

Finance

Banks make money by “buying” deposits cheaply and “selling” them at higher prices. Presumably, loftier rates will force them to pay more for deposits, but interest rates on savings accounts and other consumer products tend to ascend more slowly than those on loans. The average rate on a one-year certificate of deposit, for instance, has climbed from 0.27% to 0.78% since the start of 2016, even as that on a home-equity line of credit has jumped from 4.69% to 6.19%, according to Bankrate.com.

Since the 2008-09 financial crisis, banks have held more cash and low-risk investments on their balance sheets, to comply with regulations. All that cash is essentially dead weight when interest rates are low. But higher rates turn those deposits into income-generating assets.

Investors see higher interest rates as a key determinant for financial stocks. In the past year, financial issues have gone up by a cumulative 64.8% on days when the 10-year Treasury yield rose, and fell a cumulative 35% on days when the yield declined, according to a study by Credit Suisse.

The three biggest consumer banks, JPMorgan Chase (JPM), Wells Fargo (WFC), and Bank of America (BAC), should see particularly large benefits from higher rates because they’ve been growing deposits more quickly than the rest of the industry. As of the end of 2017, the three accounted for about one-third of all U.S. deposits, up from 20% in 2007, according to regulatory data analyzed by the Wall Street Journal.

Discount brokers are among the financial outfits with the most sensitivity to higher rates. Charles Schwab (SCHW), for instance, generated 57% of its revenue from interest income in the second quarter. Sure, Schwab makes money from trading and asset-management fees, but it makes even more by earning interest on cash and securities. A modest half-percent bump in rates over the course of a year, along with rising balances, helped Schwab make $354 million more on interest-earning assets in the quarter than it had made the year before. That accounted for 99% of its revenue growth in the period.

Utilities

On the other side of the yield seesaw are utilities, whose shares have been rising as other sectors have been sliding in recent weeks. However, strategists doubt that dynamic can last, given historical patterns.

Utilities tend to struggle during periods of rising rates because people are less interested in stocks with high yields when they can buy lower-risk investments with strong yields. It doesn’t help that utilities often carry high debt loads, which become costlier to refinance as interest rates jump. In the past year, utility stocks fell a cumulative 24.4% on days when the 10-year Treasury yield rose, but gained 31.3% on days when it fell.

The interest-rate increases could blindside investors in utilities, who so far don’t appear to have taken the higher rates into account. The Utilities Select SPDR fund (XLU), a proxy for the sector, has returned 3.1% this year. Utilities could still prove to be a hedge against a declining market, if the broader market selloff continues. During Wednesday’s rout, shares of utilities held up better than other sectors, but investors shouldn’t expect that trend to last.

“Unless we’re heading into a recession, it doesn’t make sense to put bond proxies into the equity part of your portfolio,” says Chris Zaccarelli, chief investment officer for the Independent Advisor Alliance.

Energy, materials, and industrials

Energy and materials companies aren’t helped by beefed-up rates because many carry lots of debt. Yet the stocks tend to thrive in rising-rate environments. Higher interest rates signal broader economic growth, and these companies tend to grow with the economy. Industrial stocks have trailed the broader market, largely due to concerns about trade tensions. But they look increasingly attractive, as manufacturing remains strong and companies increase capital investment after the tax cuts.

Housing and autos

Rising rates further darken the picture for home builders. The iShares U.S. Home Construction exchange-traded fund (ITB) is down 27% this year. Housing was already unaffordable for some first-home buyers before rates spiked because there are too few low-priced homes available. Now, ascending rates appear to be dampening enthusiasm even more, as shown by the recent drop in mortgage applications. Add labor shortages and rising materials costs due to the Trump administration tariffs on steel and aluminum and it’s hard to imagine a worse backdrop for the industry.

Auto stocks, which received no love from investors even in better times, are vulnerable to some of the same pressures. U.S. consumers today finance more than 86% of new vehicles and 55% of used ones. The auto industry hasn’t passed rising rates along to consumers, and manufacturers are still being generous with discounts and incentives. But they might not be able to hold the line for long.

Technology

Tech tends to outperform during periods of rising interest rates, but the stocks’ behavior might be coincidental. Tech shone as rates jumped between 1998 and 2000, for instance, but the gains came amid a euphoric run that then went bust in epic fashion. This time, the setup for tech’s highflying names also looks shaky, although not nearly as worrisome as it did during the dot-com bubble.

Big tech names, such as Amazon.com (AMZN) and Netflix (NFLX) pay no dividends and generate relatively modest earnings, compared to their valuations. They trade at such high valuations because investors believe that future cash flows will justify these lofty prices. Investors who value companies on expected cash flows discount those flows based partly on interest rates. So, as rates rise, the stocks are worth less. The recent slump in tech shares might be a result of this phenomenon.

“We’ve reduced our position in technology,” says Keith Lerner, chief market strategist at SunTrust. “When rates go up, higher P/E stocks are more susceptible to multiple compression.”

Older tech companies that fetch lower valuations and are pumping out cash flow look more attractive, some investors say. Cisco Systems (CSCO) trades for 15 times earnings, a slight discount to the market, and offers a 2.9% dividend yield, for instance. Similarly, IBM (IBM) is a “cash-flow machine” that sports a 4.5% dividend yield and continues to buy back stock, says John Petrides, portfolio manager at Point View Wealth Management.

“We’re not looking for the big momentum names” in technology, adds the Advisor Alliance’s Zaccarelli. “We’re looking for higher quality.”

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