With the Federal Reserve laying the groundwork for its first interest-rate increase in more than six years, investors may be wondering how stocks will react when the hike comes. In our last issue, Brad Sorensen, Director of Market and Sector Analysis at the Schwab Center for Financial Research, looked at the sectors that tend to do well leading up to a rate hike. But what happens afterward?
Brad and his colleagues studied the past seven Fed-tightening cycles and found that the higher borrowing costs and increased Treasury yields that follow a hike have generally worked against most sectors.
Of the S&P 500® Index’s 10 market sectors, only two—health care and consumer staples—posted gains in the six months following an initial rate increase, on average. Investors tend to flock to health care and consumer staples, which includes food and household items, because consumers consider them essential. That generally bodes well for demand.
On the flip side, the following stock sectors were the worst performers during the six months following a rate hike.
- Consumer discretionary, which includes nonessentials such as cars, luxury items and leisure goods, was the worst performer in the study. Why? Discretionary spending typically takes a hit as higher interest rates hurt demand for loans.
- Materials, which covers an array of commodity-related manufacturing industries, was the second-worst performer. This sector tends to suffer as higher rates depress housing and construction activity.
- Utilities was the third-worst-performing sector. Utilities can struggle with debt payments if rates rise rapidly. Income-oriented investors also tend to pull money out of dividend-paying utilities and funnel it toward U.S. Treasuries, which have historically offered better yields after a hike and are seen as safer than stocks.
Brad cautions that the Fed is only one factor influencing sectors. He notes that because rates have been at historical lows, things could look a little different this time around. Investors might look to past “easy hiking” periods—when the federal funds rate was less than the growth in gross domestic product (GDP)—to gain insight into how different sectors might perform after the Fed lifts rates. In the eight easy hiking periods since 1961, the S&P 500 has posted an average annualized return of 10.6%, and gains were generally seen in the more cyclical sectors—tech, industrials, energy and materials, according to BCA Research.
“Rates have been so low for so long that we’re still in an easy-money environment that is going to benefit a lot of companies and industries,” Brad says.