What a Rising Rate Environment Could Do to Stocks

What a Rising Rate Environment Could Do to Stocks

The United States Federal Reserve (the Fed) has one primary tool at its disposal to combat inflationary pressures: the Federal Funds rate (or ‘interest rates,’ as it is known colloquially). This is the rate that banks pay to borrow money that is then lent out to consumers and businesses. When the Fed raises interest rates, banks then have to pay more to source the capital that they lend out. Subsequently, banks pass on these costs to customers through higher rates charged on mortgages, car loans, personal loans, etc.

Among the others, one of the Fed’s key mandates is to control inflation and prevent a rapid increase in prices that would hurt the purchasing power of the citizens within an economy. When the Fed feels that the economy’s rate of inflation is too high, it will typically choose to raise the Federal Funds rate to slow borrowing (and thus, spending). When it feels that the economy’s rate of inflation is lower than its target inflation rate, the opposite happens. Interest rates are reduced to encourage more borrowing, which then stimulates economic growth.

What does a rate hike mean for equities?

From an equity markets standpoint, a rate hike is usually not viewed favorably – at least in the short term. There are two significant reasons for this.

The first is that when a rate hike occurs, investors generally view that as a precursor to the broader economy experiencing a slowdown. When this happens, other asset classes such as bonds start to become more attractive as compared to stocks. This causes a re-allocation of capital from equities into fixed-income assets as investors start seeking more safer or ‘guaranteed’ returns than the returns provided by higher-risk investments such as equities. As demand for equities reduces, prices tend to fall as well.

The second reason is that lenders such as banks now face increased borrowing costs when the Fed increases the benchmark rate. As discussed above, these costs are ultimately passed on to consumers and businesses through loans with a higher interest rate. As debt such as mortgages and auto loans becomes more expensive, demand for that debt reduces, slowing down consumer spending.

Additionally, businesses with a debt financing component now have to pay more to run their day-to-day operations. As a result of these increased interest costs, business profitability declines. Lower corporate earnings then translate into lower stock prices.

While selloffs are common in anticipation of an interest rate hike, the degree of the selloff often depends on the level of uncertainty that investors feel with regards to when rates will next be cut. If an economy is facing rampant inflation, the Fed can enact one or more rate hikes in a year, which can progressively cause pressure on equities. Alternatively, if the Fed signals that a rate hike is a temporary measure to cool off inflation, then a decline in equities is unlikely to be experienced for an extended period.

What stocks can you buy during a rising rate environment?

Notwithstanding the impacts that a rate hike has on broader equity markets, certain sectors remain attractive in a rising rate environment. These sectors are called ‘defensive’ sectors as they generally tend to remain more resilient through economic cycles than growth sectors like technology.

Consumer Staples

Contrary to their consumer discretionary counterparts, consumer staple stocks such as food manufacturers, grocery chains, etc., are generally considered defensive stocks. This is because regardless of external market circumstances, people will still buy items like food, water, toilet paper, etc. On the other hand, consumer discretionary stocks such as luxury retail tend to do well when the market is at or near its peak.

Financial Services

Historically, the financial services sector has tended to be one of the biggest beneficiaries of rate hikes. As rates are pushed higher, banks and other lenders pass on those higher rates to consumers and businesses, thereby increasing their profit margin. This makes financial services stocks one of the better buys during an impending rate hike.

Healthcare

Healthcare stocks of pharmaceutical companies, medical device manufacturers, and others have also historically remained stable through economic cycles. People will always need medical services to help them treat or recover from illnesses, injuries, or other conditions. As such, these stocks don’t generally fluctuate much over multiple years in the absence of a significant catalyst.

Further to the above, another asset typically benefits from rate hikes imposed by the Federal Reserve: gold. The commodity typically outperforms equity markets when equities are in decline and vice versa when equities are doing well. This is because investors view gold as a sort of ‘safe haven’ since it is a physical asset.

There are several ways to invest in gold in anticipation of a rate hike. Investors can purchase gold as a physical commodity (gold bullion) through a local or online dealer. Alternatively, they can buy gold futures if they wish to make a speculative profit. In case investors don’t want to deal with the physical hassles of owning gold or the fast-paced, higher-risk nature of the futures markets, they can also buy stocks of gold miners or ETFs that hold these mining stocks within them.  

Should I exit the equities market entirely during a rate hike?

While the immediate aftermath of a rate hike can cause selloffs in equity markets, it is generally not a wise idea to exit the market entirely. Beyond the merits of owning a diversified portfolio, equity markets have largely been able to shrug off the effects of hikes over more extended periods and reward investors who stay the course. While a revisit of portfolio allocations or a sector rotation within equities may be warranted, investors could be missing out on long-term growth by pursuing a full sale of their equity holdings.

Another trend that may pick up going into a rate hike cycle is the outperformance of active management. Active management has generally been misunderstood amid a multi-decade cyclical bull market. But when functional changes are going on in something as fundamental as the Fed rate, active management tends to get a leg up on the competition. Volatility increases, opportunities present themselves, and a more agile manager should be able to pick up highly discounted companies, futures, options, etc., at attractive valuations. Should an investor exit markets during a rate hike or rate hike cycle? No. However, they should be more open to trading opportunities as they arise.

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