Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: The Fed raised interest rates by 25 basis points on Wednesday and signaled two more hikes in 2017. What were your thoughts on the move?
Stovall: I think the Fed did what most investors had expected, which was to take the opportunity to raise interest rates. Essentially, most, if not everybody, on Wall Street was expecting them to do that because the Fed wants to make sure it doesn’t get behind the curve and it indicated that it’ll most likely raise rates two more times. So, it gives them a little more leeway as to when they will raise interest rates during the remainder of the year.
Also, their statement was not overly hawkish and did not imply that they would be raising rates four times this year—and ditto for next year—even though their terminal rate at 3% is higher than what many economists believe. I think that’s why the market responded favorably because the Fed did what they had expected. However, the duration of rate increases probably will not be as dramatic.
EQ: In this week’s Sector Watch, you looked at the market’s historical performance around rate hikes and the likelihood this one could trigger the long-awaited pullback or even correction. Will this trigger a near-term drop in the market or is it already priced into the market?
Stovall: I think that, with a third rate increase, most of the uncertainty has already been factored into the markets. Of the last 17 rate increases, the market has fallen 16 times either prior to the first increase or shortly thereafter. But once you’ve hit the second or third rate increase, it’s pretty much old news and by then, investors have been able to feel out what the magnitude and duration of this rate-tightening cycle is likely to be.
EQ: You also looked at the sectors investors may want to look at as well as avoid as the rate-tightening cycle continues. Which sectors should investors lean to, and away from?
Stovall: Looking at the average monthly performance for sectors of the S&P 500 whenever the yield on the 10-year note has risen—and remember, the Fed controls short rates while the market controls long rates—whenever we’ve had increases in the 10-year note, those sectors that did the best were Technology, Consumer Discretionary and Industrials, along with the more commodities-sensitive areas like Energy and Materials.
Those sectors that took it on the chin, not necessarily falling but certainly not performing as well as the market, were your higher dividend-yielding areas, such as Consumer Staples, Telecommunications, Real Estate, and one group that did actually post an average decline was Utilities. You can also sort of add another area that slightly underperforms in Health Care, and that’s mainly because, if the economy is expanding and interest rates are rising, then it implies that we are in a growth phase in the stock market and Health Care tends to do better in a more defensive mindset.
EQ: For investors that would like to insulate their portfolios from the Fed effect, are there any types of investment styles, sectors or sub-industry groups they can look to for the potential of lower correlation to the interest rate environment?
Stovall: Well, essentially every company that borrows money is going to be affected by the interest rate cycle because when they roll over their debt, they will likely have to do so at a higher interest rate, which will have a negative effect on retained earnings. Also, whenever analysts value the income stream, cash flow steam, or what have you for a company to come up with its intrinsic value, the higher the interest rate then the lower that intrinsic value will be. So, no company is immune, however, there are companies like those in biotech and other technology areas that don’t pay a high dividend yield that might not be pressured by rates as much as areas that do rely quite heavily on debt.