While the recent market selloff and declining inflation expectations have lowered the probability of a September Federal Reserve (Fed) rate rise, “good enough” U.S. economic data still support Fed liftoff occurring later this year. However, the exact timing of the hike—September, December or even early 2016—isn’t as important as the market implications of moderately higher rates, which are expected to come sometime soon.
Though the Fed is likely to raise rates gradually, higher short-term rates will ripple through the markets and affect a wide range of financial assets, including stocks.
The actual liftoff event will most likely lead to more short-term U.S. stock market volatility, so investors should expect a continued bumpy ride in the months ahead. That said, I do see potential opportunities in two particular U.S. sectors.
Two Sectors to Consider
Technology companies hold a staggering 40 percent of the total corporate cash reserves in the U.S., according to Forbes, so they’re much less vulnerable to rising rates than debt-laden firms, such as utilities, according to Bloomberg data as of 07/13/2015. Their strong cash positions mean they have the potential to continue on with their shareholder-friendly policies, such as share buybacks, dividend increases and M&A activity. In addition, while tech valuations have risen in recent months, current levels suggest that there may be additional room to run. As of last month, tech companies, as measured by the S&P 500 Information Technology Index, traded with a 6 percent price-to-earnings (P/E) discount to the S&P 500, well below the trailing 10-year average of a 12.7 percent P/E premium, according to Bloomberg data.
Financials Sector (excluding rate-sensitive REITs)
For some financial institutions, namely banks, higher rates could potentially translate into higher revenues. In an environment of rising rates, the difference between what banks make from lending (their revenue) and what they pay for deposits (their costs) may increase, so banks potentially stand to increase profits. In addition, in anticipation of higher rates, many banks have begun to reposition their balance sheets toward variable rate loans, so they won’t be locked into low interest rates, and they’re hedging their interest rate exposure, according to banks’ most recent earnings reports and earnings calls with analysts.
It’s also worth noting that U.S. financials were the bright star of second-quarter earnings—roughly 60 percent of financials beat revenue expectations, well above the overall sector average, according to Bloomberg data. Beyond strong earnings, financials also represent a relative bargain compared to some other sectors. For instance, the financial sector is still among the cheapest S&P 500 sectors in both P/E and price to book (P/B) terms, and its P/B ratio is just half that of the broad U.S. market, according to Bloomberg data.
Finally, both U.S. technology and U.S. financials are cyclical sectors. When the economy is strong, as it tends to be in a rising rate environment, cyclical stocks typically outperform. In contrast, defensive sectors (think utilities) tend to outperform the broader U.S. market when economic growth slows, and as rates rise, they can be vulnerable, given that they may have significant debt loads.
Exchange traded funds (ETFs), such as the iShares U.S. Technology ETF (IYW) and the iShares U.S. Financial Services ETF (IYG), can provide access to the U.S. Tech and U.S. Financials ex-REITs sectors.
Heidi Richardson is a Global Investment Strategist at BlackRock. She is also Head of Investment Strategy for U.S. iShares.