Will rising interest rates in the next few years deflate the stock market? That fear caused the Dow Jones Industrial Average to plunge by more than 550 points within a few days in June. But the stock market actually has done quite well in some past periods of rising rates. And certain kinds of stocks could do especially well.
Bottom Line/Personal asked noted investment strategist and market trends researcher Pat Dorsey for his take on the market outlook and what kinds of stocks he thinks may benefit the most—and what kinds may suffer the most—from higher interest rates…
DANGER LEVELS FAR OFF
When long-term interest rates get high enough, they will slow economic growth and eventually kill the bull market in stocks—that’s what almost always happens in economic cycles. But in my view, we still are in the very earliest stages of a rising-rate environment—not anywhere near dangerous levels.
The interest rate on 10-year Treasury bonds, a key benchmark, spiked from less than 1.7% in early May to as high as 2.7% in early July, with some analysts saying it could hit 3% by next year and even 4% by 2016.
What most investors don’t realize: In the past, the Standard & Poor’s 500 stock index has gained an average of 1.7% a month during rising interest rate periods when 10-year Treasury yields were between 3% and 4%. Historically, investors tend not to lose confidence in stocks until rates hit 6%, which we likely won’t see until beyond 2016. At that level, higher interest rates become a drag on the economy as they discourage consumer and business borrowing—and they lure many more investors away from stocks into bonds.
What about short-term interest rates? The Federal Reserve has more direct control over those than it does over long-term rates, and one day—when inflation is accelerating above its very low current levels—the Fed will start raising short-term rates again to keep the economy from overheating. But contrary to what many people think, even that will not necessarily spell the end of stock gains. In fact, a gradual rise in short-term rates, such as the Fed undertook from June 2004 to June 2006, could allow stocks to continue gaining for a while. During that stretch of 17 rate increases, the S&P 500 rose 11%.
HOW TO INVEST NOW
How do higher interest rates affect individual companies? Slow-growing businesses and those that need to borrow lots of money may struggle and see their stock prices sag. On the other hand, cyclical businesses such as technology and asset-management companies, which do best in fast-growing economies, as well as companies that generate enormous cash flow and can earn increasingly higher interest income on their cash will see higher profits.
Types of companies that are likely winners…
WINNER: CASH-RICH COMPANIES
Many businesses started hoarding cash after the 2008 recession, fearing another credit crunch. With higher interest rates, these companies can earn better money on their cash and increase their profits. Companies that naturally accumulate large amounts of cash because of the nature of their businesses also benefit. Examples…
Property and casualty insurers benefit from the “float”—the enormous cash reserves that result from the premiums they collect each month but have not yet had to pay out in claims. For example, the float from the insurance divisions of Berkshire Hathaway (BRK.B), the company led by Warren Buffett, has accumulated to about $50 billion. Insurance premiums also have been heading up, and they typically go even higher when inflation starts to rise.
Payroll processors benefit from interest income on a different kind of float. Businesses outsource their payroll services to processors such as Paychex (PAYX), which serves more than a half million employees at small and medium-sized businesses in the US. Paychex’s float is created by the lag time between collecting payroll money and issuing paychecks. Also, a stronger economy means companies add more employees. That will help Paychex’s revenues and profits.
WINNER: TECH GIANTS
Large-cap technology stocks usually are market leaders when interest rates are rising. That’s because the companies sell more software and equipment as consumers and businesses typically increase their tech spending in a growing economy…and they earn higher interest rates on their massive cash reserves.
Examples: Apple (AAPL) has about $145 billion in cash…Microsoft (MSFT), $75 billion…and Cisco Systems (CSCO), $45 billion.
WINNER: FUTURES EXCHANGE
As interest rates rise, more and more investors will want to protect their portfolios against rising rates by using futures and other derivatives that allow them, for example, to bet against falling bond prices.
Example: CME Group (CME) owns the Chicago Mercantile Exchange, the country’s largest exchange for trading futures. Increased trading volume would boost investor interest in the company.
WINNER: FINANCIAL-SERVICES FIRMS
Brokerage and banking stocks tend to do the best of any market sector in the initial phases of interest rate increases.
Examples: Both Charles Schwab (SCHW) and Wells Fargo (WFC) are likely to profit for the next year or two from the fast-growing spread between the short-term interest rates that they pay depositors and the long-term interest rates at which they can lend money. In addition, many Schwab investors are likely to dump their bond funds, whose values are dropping as bond yields rise, and move money into the stock market. That allows the company to collect more financial advisory and stock-trading fees. Wells Fargo also is a major mortgage lender and should benefit from the rising demand for mortgage loans in the next year, which will more than offset a sharp drop in refinancing. More buyers will jump into the housing market when they realize that fixed-rate mortgages and housing prices are likely to keep climbing.
As yields on 10-year Treasuries rise, certain types of companies typically have been hurt. They include…
Highly leveraged businesses such as telecommunications firms, utilities and real estate investment trusts (REITs). They need to take on substantial debt in order to support expansion. In fact, REITs are prohibited by law from retaining more than 10% of their annual earnings, which makes them heavily dependent on loans to acquire new properties. Rising rates will increase the burden of these companies’ debt payments, cut into their profitability and hurt their stock prices.
Blue-chip dividend payers. Investors have poured into the stocks of these companies as an alternate source of fixed income in recent years because their hefty annual dividends, consistent cash flow and relatively low volatility made them attractive. But many of the stocks now are richly valued, and their dividend yields compare less favorably to rising yields on Treasuries.
For instance, at the beginning of 2013, more than half of the dividend-paying stocks in the S&P 500 had a higher yield than 10-year Treasuries. By the end of June, only about one-third did. This doesn’t mean that you should dump all your dividend stocks, but you need to review their long-term potential and whether they still make sense as a bond substitute.
Companies that rely on low-cost loans to spur consumer demand such as auto manufacturers and home builders. They eventually will see less demand and lower profits as interest rates rise. This won’t happen right away because both car loans and fixed-rate mortgage loans still are quite affordable. But the stock prices of many of these companies have had big run-ups in the past year, and investors already are worried that higher rates could slow the housing recovery and the market for new automobiles.