Will the Fed hike interest rates?
History shows some investments fare better than others during this time
Is your investment portfolio built to thrive when interest rates rise?
Now is a good time to find out. After years of low borrowing costs, rates appear to be headed higher as the U.S. economy improves, inflation ticks higher and jobs become easier to find.
After another month of strong hiring in February, when a better-than-expected 235,000 jobs were created, Wall Street is now almost certain the Federal Reserve will increase rates when its two-day meeting ends Wednesday — the second time since December. And looking ahead, better business conditions and signs of inflation in consumer goods could prompt the U.S. central bank to hike borrowing costs four times this year, instead of the three the Fed anticipated back in December, notes Bill Stone, chief investment strategist at PNC.
Fed rate increases are intended to keep the economy from overheating, as well as to rein in speculation on Wall Street.
In the past, certain investments have fared better than others under these conditions.
Stocks in the sweet spot: The stocks that perform best when borrowing costs rise are companies that do better when consumers are in a spending mood, businesses are in expansion mode and overall confidence is high, which typically is the case in ratehike periods.
In Fed rate-hike cycles dating to 1962, the types of large-company stocks that shine include technology names, energy producers, as well as industrial and transportation firms. These stocks are dubbed cyclical, because they do well when the economy is on an upswing.
The fact that the Fed has enough faith in the economy to boost rates is a good thing, says James Paulsen, chief investment strategist at Wells Capital Management.
“Finally, confidence in the future starts to dominate over fear,” Paulsen explains, adding that the market is undergoing a character change that benefits stocks that can boost profits even as rates go up.
The stocks that make the least sense to own are companies deemed defensive, or those that pay out a lot of cash to investors in the form of dividends, and which investors flock to in tough times. Examples include utilities like electric and water companies, stocks in telecom that provide must-needed phones and other communications gadgets, as well as companies that sell everyday products, such as toilet tissue, cereal and liquor.
“When rates rise, these socalled ‘bond proxies’ lose their attractiveness,” says Sam Stovall, chief investment strategist at CFRA. Investors that found the current 3.6% yield on utility stocks attractive might view them as less enticing when bond yields move higher. Higher-yielding stocks, of course, also run the risk of seeing their share price fall.
With the economy strong, investors should not fear a Fed rate hike Wednesday, Paulsen says.
“We caution stock investors against becoming too pessimistic,” he says.
Best bonds to buy: In a rising rate environment, the price — or the value of the principal — of a bond falls. Boris Rjavinski, an interest rate strategist at Wells Fargo Securities, offers a number of strategies that bond investors can use to survive falling prices.
For buy-and-hold investors, Rjavinski stresses that any bond purchased outright can be held to maturity, at which time the investor will get back his full initial investment, as well as collect interest payments along the way. “As long as you don’t sell the bond when prices fall and yields rise, you will get your principal back, assuming the borrower did not default,” he says.
Electric and water utilities are among the stocks that make the least sense to own.