Don’t be afraid to invest when rates are rising
History shows S&P index can thrive
Stocks and rising rates: Average monthly returns¹ for S&P 500 stocks when 10-year Treasury note is rising
Is it time to rate-proof your investment portfolio?
With a recent spike in borrowing costs causing swings in the market and angst on Wall Street, now might be a good time for investors to consider rejiggering their portfolios and shifting toward investments that fare better when interest rates are rising.
A market-moving shift appears to be underway. The long period of historically low rates in place since the 2008 financial crisis – which enabled homebuyers to get cheap mortgages, car shoppers to obtain 0 percent loans and corporations to grow their businesses and profits with the help of cheap money – is reversing as investors and the Federal Reserve, reacting to an improving U.S. economy, push borrowing costs back toward more normal levels.
The Fed has hiked short-term rates three times this year, raising its key rate – which it slashed to zero in 2008 – to a range of 2 percent to 2.25 percent. Adding to investors’ concern is the recent rise in the yield on the 10year Treasury note to above 3.25 percent, a seven-year high.
Investors fear that higher rates will slow the economy and dent corporate profits. Those potential obstacles have caused increased market volatility on Wall Street in the past three trading sessions, with the Dow Jones industrial tumbling more than 340 points. It also has changed the outlook for many types of investments, from stocks to bonds to real estate. As a result, “portfolios need to shift” to respond to the changing risk and reward profile of different investments, Michael Wilson, equity strategist at Morgan Stanley, wrote in a research report.
Despite conventional thinking that rising rates are bad for stocks, historical data show that the broad Standard & Poor’s 500 stock index has in fact posted strong returns. Stocks moved higher in 12 of the 15 periods since 1950 when the 10-year Treasury yield was rising, or 80 percent of the time, according to data from SunTrust Advisory Services. In fact, the S&P 500 posted average annualized returns of 12.6 percent during those 15 periods.
Trying to pinpoint how high the yield on the 10-year note must climb before it becomes a major hindrance for the stock market is tough to decipher.
Credit Suisse’s chief U.S. equity strategist Jonathan Golub cites 3.5 percent as a threshold to watch, while Lindsey Bell of Wall Street research firm CFRA cites 4 percent, and Bank of America Merrill Lynch says it would have to jump to 5 percent before bonds would look more attractive than stocks.
Here’s a basic game plan, based on past history, on what to own and what to avoid when interest rates are rising:
❚ Stocks to buy ... and avoid: The best companies whose stocks you should own when borrowing costs are rising are those without a lot of debt and plenty of cash on hand, says Brian Belski, chief investment strategist at BMO Capital Markets. His firm cited a list of stocks that fit this profile, including A.O. Smith, which makes water heaters, video game maker Electronic Arts, health insurer Humana and semiconductor giant Intel.
Some segments of the market fare better than others when the 10-year U.S. government bond is moving higher. The top performers going back to
1970 are tech stocks, energy shares, companies that sell discretionary goods to consumers and big industrial companies, according to data from CFRA Research.
What sectors to favor depends, in part, on why borrowing costs are becoming more expensive, says Brad McMillan, chief investment officer at Commonwealth Financial Network.
“When rates are rising because of faster growth, you want to be in overweight sectors that benefit from that growth, like financials or technology,” McMillan explains. “When rates are rising because inflation is rising, you want to be exposed to sectors that trade in things that will be affected by inflation – such as energy.”
Banks also are viewed as a good place to park cash when rates are rising, according to Belski.
The parts of the market that normally feel the most pain when rates are rising are those that investors seek out for income and which pay out sizable dividends, such as utilities, real estate and telecom, McMillan says. These interest rate-sensitive stocks are known as “bond proxies.” Real estate companies in the S&P 500 now yield 3.58 percent, while utilities are yielding close to 3.5 percent, data from S&P Dow Jones Indices show. The interest payout on the 10-year Treasury is approaching those levels.
❚ Bond strategies to consider: The bad news for current bond holders is that when yields rise, the price of the underlying bond falls. But the good news is that rising income payments from the higher-yielding bonds over time will more than offset the loss of principal and leave investors with a positive total return, a BlackRock analysis of the last rising rates cycle from 2003 to 2006 found.
Investors putting money in the bond market will benefit from the higher yields. The current 3.25 percent yield on the 10-year Treasury, for example, offers a far better risk-free return than it did in October 2016, when the yield was closer to 1.75 percent.
❚ Real estate pain: Rising interest rates mean more expensive mortgages, which crimps affordability for prospective homebuyers. And if fewer people can afford homes, that could cause real estate prices to stagnate or fall, crimping the buildup in equity of current homeowners, analysts say.