November 30, 2005

Rising Rates Rank Near Top of Investor Worries

How will stocks weather the change in climate?

Rising interest rates rank near the top of investors' worries as the Federal Reserve continues to tighten credit to keep a lid on inflation. How should stock and fund investors respond to higher rates? Should they even fret?

Earlier this month, the Federal Reserve boosted the fed funds rate by 25 basis points to 4.00%, representing the twelfth straight rate hike since June 2004. As the Fed prepares to install a new chairman, Ben Bernanke, next year, the central bank is probably not done raising rates, according to Standard & Poor's Global Investment Policy Committee (IPC).

"We believe the Fed will vote to raise rates 50 basis points at the December meeting, and then make no change at the January 31 meeting," IPC said in a statement. "This would signal the end of the rate hikes, in our view, and allow Chairman Bernanke more freedom in setting policy after January 31. If the Fed raises rates a quarter point in both December and January, however, we think it will be hard for Chairman Bernanke not to raise again in March. As a result, we believe the Fed will probably end at 5.0%."

What does all this mean for stock pickers? Investors would be wise to remember four important things about rising rates: It takes up to one year for a change in rates to work its way into the economy and markets; stock prices anticipate rate changes well ahead of time, and respond accordingly; although rates are rising, they still remain at historical lows; and rates are only one component of a vast and complex macroeconomic system.

Indeed, since June 30, 2004, when the Fed initiated its current credit tightening scheme, the S&P 500 gained 8.3% through Nov. 1, 2005. Over that period, short-term rates quadrupled to 4.00% from 1.00%. Similarly, the S&P 400 Mid-Cap index rose 17.0%, and the S&P Small-Cap 600 Index climbed 15.8% over that period. Rising rates didn't dent equity returns. Though they were coming off of a low base in this period, stock markets have still performed well in anticipation of the end of rate-tightening cycles, according to Sam Stovall, chief investment strategist at Standard & Poor's. Stovall said that since the early 1970s, the S&P 500 advanced an average of 3% in the three-month period preceding the last rate increase of a tightening period.

By the same token, falling interest rates do not necessarily translate into booming stock prices. For example, between January 3 and December 11, 2001, the Fed cut short-term rates from 6.50% to 1.25%. However, over that period, the S&P 500 declined 12.4%, and the S&P Mid-Cap 400 rose a meager 1.4%. The small-cap Russell 2000 index did, however, record a 3.1% gain. But with the dislocation inflicted by the September 11 terrorist attacks, it was hardly a "normal" year.

While rising rates may not always dramatically hurt the equity markets as a whole, they clearly impact specific sectors. Traditionally, during periods of tighter credit, investors are advised to move out of "rate-sensitive" industries (banks, financials, utilities, REITs, among others) and shift into "safer" defensive segments of the economy (food & beverages, health care), which can prosper regardless of a credit crunch.

However, Quincy Krosby, chief investment strategist at The Hartford, points out that even among sectors that tend to incur losses during periods of climbing rates, investors can still find pockets of outperformance. For example, among financials, she thinks brokerage companies may continue to do well, because the market "knows M&A activity will continue to be strong."

Jerry Jordan, portfolio manager of the Jordan Opportunity Fund (JORDX) said, "theoretically, when rates rise, you're not supposed to own financials. That adage still holds true, but at some point, the market discounts that."

John Buckingham, manager of the Al Frank Fund (VALUX), opined that when rates rise, it is time to start investing in stocks, particularly in sectors that will be hurt by the tightening. For example, based on anticipated higher interest rates, financials and homebuilders have "already sold off, and they represent good value," he said. "As a result, I want to be buying financials like Citigroup Inc. (C), Countrywide Financial (CFC) and H & R Block (HRB), and homebuilders like D.R. Horton Inc. (DHI)."

Similarly, Krosby counters that rising rates may not hurt all consumer stocks either. "The consumer represents about 70% of the economy," she said. "Granted, higher rates, higher energy costs this winter, plus credit card debt, will cut the spending power of lower-income consumers. But, the bulk of spending comes from middle- and upper-income consumers who will still purchase consumer discretionary products, which we call the 'affordable luxury goods' sector."

Size may also play a role in stock selection during periods of rising rates. "When interest rates move up, economic growth slows down," said Rosanne Pane, mutual fund strategist at Standard & Poor's. "Investors are attracted to companies with high-quality and consistent growth. This tends to favor the large-cap companies. On the other hand, small-cap stocks, which usually exhibit higher growth rates, tend to perform better when the economy is rebounding, as we saw in 2003." Jordan concurs. "Rising rates presents more of a negative factor for small-caps. Large-cap companies have stronger balance sheets, and don't depend on the capital markets as much."

Historical data show that after a period of credit tightening ceases, certain key sectors have performed very well over the next twelve-month period. For example, on Feb. 1, 1995, the Fed completed a year-long tightening campaign that saw interest rates double to 6.00% from 3.00%. For the one-year period ending Feb. 1, 1996, the average sector fund in five key sectors -- financials, health care, real estate, technology and utilities -- delivered powerful gains. (see Table 3 below).

Jordan said he is concerned by today's higher rate environment, having recently moved 15%-20% of his fund's assets into cash. Looking ahead, he is moving into areas that he believes will do better in a declining market and slower economic environment, including big pharma, generic drugs, hospitals, biotech, and some consumer areas.

"Historically, as rates rise, commodity-oriented, cyclical and industrial sectors have done better than the overall market because rising rates confirm that the underlying economy is strong and that business continues to be good," Jordan said. But at some point, he added, "the market discounts an eventual economic slowdown, and rotates into companies that can continue to grow earnings during an economic deceleration."

Buckingham said he is optimistic about equities overall because "interest rates will likely remain relatively low for the foreseeable future. I don't think we'll see double-digit rates in our lifetimes."

Equity Index Performance During Periods of Interest Rate Rise

Period of Credit Tightening

Magnitude of Rate Hike

S&P 500 Index Return*

S&P MidCap 400 Index Return*

Russell 2000 Index Return*

June 30, 2004 to Nov. 1, 2005

1.00% to 4.00%

+8.3%

+17.0%

+11.0%

Feb. 4, 1994 to Feb. 1, 1995

3.00% to 6.00%

+3.1%

-4.8%

-4.2%

Equity Index Performance During Period of Interest Rate Drop

Period of Credit Loosening

Magnitude of Rate Drop

S&P 500 Index Return*

S&P MidCap 400 Index Return*

Russell 2000 Index Return*

Jan. 3, 2001 to Dec. 11, 2001

6.50% to 1.25%

-12.4%

+1.4%

+3.1%

Average Fund in Sector

Return from Feb. 1, 1995 to Feb. 1, 1996

Financials

43.0%

Health care

47.9%

Real Estate

20.1%

Technology

44.6%

Utilities

26.6%

SOURCE: Standard & Poor's.

*Aggregate Return

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