By Kira Brecht
With the 2008 global financial crisis finally in the rearview mirror, improvement in the U.S. economic picture has increased expectations that the Federal Reserve will raise interest rates in 2015.
The Standard & Poor's 500 (^GSPC) index has been climbing in a bull market since March 2009, fueled in part by low interest rates. Does that mean rising interest rates could end the bull market in equities? Don't despair. Certain sectors could actually benefit from a rising interest rate environment.
The first thing investors should understand is that the Fed is moving toward raising interest rates because there has been broad-based improvement in the economy and labor market. "Rising interest rates typically go hand in hand with an improving economy. That's a good thing," says Pat O'Hare, chief market analyst at Briefing.com, a live market analysis company in Chicago.
"A period of rising interest rates that is gradual can be beneficial to stock investors and doesn't necessarily spell the end of the bull market," says David Blain, chief executive officer at BlueSky Wealth Advisors in New Bern, North Carolina.
Looking Into the Crystal Ball
Looking ahead, higher interest rates can eventually influence both economic and earnings growth. The Fed is starting from a historically low level of near-zero interest rates, and initial hikes are expected to be slow, so the impact from higher rates won't be immediate. This is a time investors should be choosy, however, when picking stocks and stock mutual funds.
%VIRTUAL-WSSCourseInline-449%"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," O'Hare says.
While in previous years, a rising stock market generally may have lifted all boats, investors today may have to do more research. "Stick with companies with strong balance sheets and minimal need to borrow," Blain says. "Look for a lot of cash to continue paying dividends. Stay away from weaker companies that may be impacted with higher borrowing costs."
In the early stages, however, the stock market could have a nonchalant reaction to a modest rise in interest rates. Markets tend to price in events even before they happen. "Most of this is already priced into the stocks you are looking at. The Fed has been telegraphing rate increases, and repositioning has already taken place," Blain says. Here are three sectors investors should watch that could benefit from rising rates.
Companies such as automakers, casinos, homebuilders, apparel retailers and cruise lines comprise this large and diverse sector.
"The early part of a rate hike cycle should be beneficial to the consumer discretionary sector. 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, and that leads to higher levels of spending," O'Hare says.
Investors looking to boost exposure to the consumer discretionary sector without the risk of investing in individual stocks could consider an exchange-traded fund, such as the Consumer Discretionary Select Sector SPDR (XLY).
The financial sector is also poised to benefit from rising interest rates. "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," O'Hare says.
"Financials benefit from rising interest rates because the interest margin expands, creating more profit, and the increased economic activity that caused the rate hike generally means more loan demand," Blain adds.
Insurance companies also could benefit through the ability to earn higher returns on the premium income they collect from policyholders. O'Hare points to a number of stocks in this sector worth watching: Bank of America (BAC), US Bancorp (USB), Chubb (CB), Allstate (ALL), MetLife (MET), BlackRock (BLK), T. Rowe Price (TROW) and Franklin Resources (BEN).
Technology stocks have boasted strong dividend growth in recent years. "I think big tech is in a nice sweet spot," says Charles Sizemore, founder of Sizemore Capital Management in Dallas. "Rising yields generally mean that the economy is improving, which should be good for tech companies that depend on corporate spending. Think Cisco (CSCO) or Microsoft (MSFT)."
He adds: "Intel (INTC) and Microsoft have both been hit hard lately, and sentiment is pretty rotten toward both, based on tepid demand for PCs. But with a new version of Windows coming out this summer and office employment looking up, we could see some pleasant surprises here."
Get Ready for Volatility
As the Federal Reserve readies for interest rates hikes, there will likely be more volatility in the stock market than investors have been accustomed to in recent years. But at least in 2015, the number and pace of rate hikes should be minimal, with perhaps only one or two modest rate increases this year.
"This is a unique time in history," O'Hare notes. The Fed has held its official monetary policy interest rate, the federal funds rate, near zero since 2008. "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," O'Hare adds.
For investors, the tried-and-true approach of diversifying your portfolio may be the best approach, no matter the interest rate environment.
"It's been a while since we've had a sustained rising interest rate environment. It's very tough to say what exactly the reaction will be. We advocate broadly diversified portfolios for this reason," Blain says.
For many investors, the best approach may be to think about their long-term financial goals. "A good rule of thumb here is Warren Buffett's advice to buy on the assumption that the market could close for five years. If you'd be comfortable holding a stock for the next five years, come what may, then that is a stock you could hold through a tightening cycle," Sizemore says.
By Kira Brecht