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).”