While bond investors have potentially more to lose when rates start to climb, the good news for them is that the remedies are relatively simple and straightforward. The reverse set of conditions tend to exist for equities investors; while rising rates don’t represent as clear and direct of a problem for them, which is certainly good, there is no consensus on how those in the stock market should react when rates go up, because of the breadth of variables at play in equities investing that does not exist within the realm of debt securities. This month, we want to take a peek at anything special that equities-oriented investors should be considering on behalf of the same broad economic activity.
First, it has to be remembered that rises in interest rates generally signify something good; when rates rise, it is because the overall economy is improving, and while it is reasonable to question the overall soundness of our financial infrastructure over the long term, it is just as reasonable to accept that that there is some legitimacy to signs that the economy is getting better, especially given how mired in stagnation it has been for so long now. So, better economy, better stock market, right? You would certainly think so, at first blush, but not so fast. The truth is that rising rates can yield a distinct headwind effect on the market, counterintuitive for most casual observers, for basically two reasons: first, higher interest rates means that it will cost businesses more to borrow money and otherwise invest in the expansion of their operations. This is a big one, because investors realize that the higher costs will translate into far less enthusiasm on behalf of the companies’ representative shares, and will impact earnings, as well. The other reason higher rates can hurt stocks is because those instruments that are beneficially influenced by a rise in rates…like bank CD’s, for example…will become increasingly attractive to some, and prompt a wave of selling. This is a problem, in particular, when it comes to those stock market investors who have been in equities somewhat unwillingly to begin with; many people who prefer to stay away from the inherent volatility of the stock market will nevertheless take the plunge when rates are rock-bottom low and the more secure vehicles they much prefer, like CD’s and short-term bonds, are paying next-to-nothing. However, lots of those folks are all-too-happy to make the move out of stocks and back into the more sedate alternatives when rates move in their favor.
So how should a die-hard equity investor position himself for a secular (long-term) rise in rates? First of all, the equity investor should remain mindful of the fact that any industry that is especially sensitive to movements in rates can be problematic. A glaring example of this includes utilities stocks, but can also include any manufacturer that derives a direct and obvious benefit from the consuming public when rates are low, like those that fit neatly in the bigger-ticket cyclicals category – cyclicals are stocks of companies that make things people tend to buy when times are good, but when rates rise, the bigger-ticket cyclical items for which many people rely on credit to purchase…like cars, high-dollar furnishings, and appliances…don’t move as well. Rising rates obviously create an unfavorable environment for real estate, as well, so real estate investment trusts (REITs) deserve your wary eye in those conditions. In a nutshell, think of those sectors of the economy that are especially owing to low rates in order to do well, and consider those as possible problem industries as rates move back up.
Now, as for financial services stocks, those can be a little tricky. When the yield curve is steep, the difference between what banks are paying depositors vs. what they charge borrowers can be sizable, and in cases like that, bank stocks can be good plays. However, when that difference is smaller, the issues can be real plodders.
Over the last seven decades, the two sectors of the economy that have performed the best during the initial 12-month period that followed the first time rates were hiked at the outset of each cycle of secular increases were technology and health care, in that order. Perhaps the biggest reason for technology’s rise during these periods has to do with its acute usefulness to businesses when the overall cost of doing business increases – technology lets businesses cut costs by replacing both people, as well as other, more expensive and less-agile systems. As for health care, well, it is the ultimate defensive issue; the goods and services represented by the health care industry exist to quite literally sustain life, which is something people need to do regardless of what else is going on in the economy.
If you’re an entrenched equity investor, then you’re likely still a longer-term investor, and if that’s the case, you by no means need to go into panic mode as signs of rate increases become more apparent. Still, there’s no reason to take beatings in your portfolio if you don’t have to, so pay attention to the fact that the market won’t be sailing along in the coming climate as it has been doing for a while now – if you have a smartly-diversified portfolio, anyway, the changes you need to make may be more like minor adjustments, anyway, but don’t be lazy about making them if your analysis reveals they’re warranted.
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