4 Stock Sectors Poised To Benefit From Fed Rate Hike

Talk about a glass-half-full portfolio plan.

Prospects for higher U.S. interest rates bring out the optimists and pessimists in equal force. Bulls remind the worrywarts that the Federal Reserve will only raise rates because the economy can finally chuck aside its crutch. Bears note that markets historically have not responded well to the onset of higher-rate cycles.

Depending on which economist you ask, central bank is expected to hike its benchmark fed funds rate around June, or it might wait until September, or perhaps even later. Nobody really knows for sure. Whenever it happens, it will be the first such rate increase since 2006. Once a rate hike occurs, markets face the onset of a tighter-money phase—higher and higher rates over at least a few years as the Fed aims to keep inflation in check and, hopefully, avoid the excesses that led to the 2008–09 financial crisis.

A decade has passed since our previous Fed tightening phase, and much has changed. What does that mean for stocks? Interest rates affect different businesses and industries in different ways. Here are a few sectors that may actually benefit from rising rates:

The Money Game. Traditional banks and insurance companies can pull in more funds with higher interest rates. Higher rates help insurance “float” portfolios earn more. Float is the gap between premium collection and claim payout. As that portfolio sits around, it needs to collect interest for the insurer. What’s more, banks that focus on traditional lower-risk community lending, more of a savings-and-loan model, will also potentially benefit from rising rates on the money they lend. Conversely, the trading risk that can come with higher rates can make investment banks increasingly risky.

Tech Leaders. Innovation can carry its own pricing power. Nimbler, experimental biotechnology firms producing breakthrough drugs and treatments could be just the creative risk-takers whose growth could outrun the general economy. Of course, these are also riskier stocks (in part due to uncertainty over government approvals) that should be considered only as part of a diversified stock approach. The same pro-growth stance may apply to tech firms that are first to market with innovation to help companies and individuals operate more efficiently.

Big Spenders. Calling Captain Obvious. Consumer discretionary stocks tend to outrun consumer staples and other slower-growth stocks because … yep, consumers spend more when the economy is heating up. Key for this pick is combing for attractive valuations and hidden gems in a category that could itself get pretty expensive. Investors might pick specific retailers or think about the growing e-commerce marts that offer all kinds of goods, both frivolous and fundamental.

Plots of Land. Real Estate Investment Trusts, or REITS, can benefit from healthy rental income and cash flow in a cyclical upswing and, in theory, pass that along in dividends. Although REITs can be illiquid, and thus riskier than traditional stocks, they tend to have relatively stable costs and have borrowed cheaply but will presumably collect higher payments as inflation pushes up rents and lease rates.

Things are Different This Time

As the markets brace for the next Fed tightening phase, there are a couple factors worth noting that may make this cycle different from previous ones, according to Michael Dolega, Senior Economist with TD Bank.

Firstly, whether a rate hike comes in June, September or any other time this year, “the Fed is likely to be quite patient with its pace of increases,” Dolega said.

During previous tightening phases over the past two decades, the Fed raised rates by about 200 basis points (2 percentage points) per year.

The impending tightening cycle shapes up to be “much more muted,” Dolega said, with rate increases likely more along the lines of 100 to 125 basis points a year.

Secondly, rates at the “long” end of the Treasury yield curve (referring primarily to 10-year notes and 30-year bonds) probably will rise, but at the same time face pressure from money piling into U.S. debt, which offers higher yields than that of many other major economies, Dolega said.

By contrast, long-term bonds in Germany and Japan “are yielding next to nothing,” Dolega said. “This is likely to continue,” given the weak economic outlook in Europe and Japan. As a result, the yield curve may flatten as the Fed starts to hike rates, he said.

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