Before last year’s long-awaited Fed rate hike, many investors speculated about what it would mean for markets. But even with “liftoff” officially underway, it’s still difficult to assess which parts of the market may thrive or lag in a rising-rate climate.
Brad Sorensen, managing director of market and sector analysis at the Schwab Center for Financial Research, credits much of the uncertainty to the atypical qualities of the rate hike. “It’s important for investors to pay attention to historical trends, but in many ways this is a unique rate hike cycle,” he says. “Some of the patterns we’ve seen in the past may not apply to markets now.”
Expect the unexpected
According to Brad, rate hike cycles are typically defined as “easy” or “tight”—based on whether interest rates are below or above the rate of GDP growth, respectively. The current cycle technically qualifies as “easy,” and historically, that has boded well for three sectors: energy, industrials and technology.
But things could play out differently this time, with this rate hike cycle marked by several economic factors that distinguish it from previous ones.
To start with, the Fed didn’t raise rates last December to combat inflation so much as to normalize monetary policy. Keeping the Fed funds rate near zero for so long was an unprecedented emergency measure, Brad notes, and the move to hike rates was a step toward restoring standard lending practices. A different lending landscape will likely have implications for businesses and consumers.
Also, unlike the outset of most other rate hike cycles, economic growth in the U.S. is still somewhat slow—and there is a risk of recession abroad.
Another complicating factor in the current cycle is the extreme drop in the price of oil, which makes the energy sector—usually a stalwart in rising-rate environments—less appealing.
New climate, new outlook
Given this unusual combination of factors, there are two sectors that could benefit from the current interest rate climate, Brad says: financials and technology.
Financial companies typically benefit from rising rates because they can charge more interest to borrowers, especially if longer-term rates go up while the Fed remains cautious with short-term rates. And even a modest increase in the Fed funds rate signals some economic growth, which could mean more borrowing—by both businesses and individuals—and a lower likelihood of defaults.
As for the technology sector, companies typically invest in new infrastructure and equipment upgrades during a strengthening economy, Brad explains. At the same time, a tightening labor market could further drive technology spending, as businesses take steps to become more efficient without increasing headcount.
Where to be wary
Which sectors are not poised to thrive? Brad suggests taking a cautious stance with utilities, telecommunications and consumer discretionary.
The capital-intensive nature of the utilities and telecom sectors can make rate hikes painful from a business perspective. And this time around, these sectors also face the challenge of being overpriced, owing to income-seeking investors who sought yield from dividend-paying equities during the recent long period of low rates, Brad says.
That said, investors who have held utility and telecom stocks for income may instead turn to more stable bonds, whose yields will likely improve.
Another sector that could suffer further down the road is consumer discretionary, especially if rates continue to rise, Brad says. Higher rates could make credit more expensive for consumers, curtailing their spending power.
What may lie ahead
If the Fed continues to boost rates (as is expected) and economic growth remains relatively sluggish, the current easy rate hike cycle could become a tight rate hike cycle. In that scenario, investors would want to consider moving more into defensive sectors, such as healthcare and consumer staples. Brad adds that financials also tend to do well during the early stages of a tightening cycle.
However this current cycle plays out, “it’s important to keep an eye on a wide range of economic variables,” Brad says, and not just watch the headlines to see whether the Fed is raising rates in a given session. By asking a broader set of questions, investors can better understand how a given rate cycle will impact different market sectors. Those economic factors, he notes, are always in flux.