In an environment in which interest rates have been steadily rising — the 10-year US Treasury yield has moved up almost 75 basis points since its recent low in September 2017 — one question that investors face is the potential effect of this phenomenon on equity sectors. Which sectors might be winners or losers in a rising rate environment?
The answers to this question could, at first blush, seem fundamental or textbook. Close consideration of the factors at play in a rising-rate environment, however, shows that stock price movements related to rate changes may be nuanced and can vary from cycle to cycle. For these reasons, an active investment approach can be essential to evaluate the impacts of interest rates and to identify resulting opportunities.
Interestingly, while some sectors may be expected to outperform during periods of rising rates, that performance success is often a result of correlation to the rate movements rather than causation.
As one example, industrial stocks often do well as rates move up. It’s not the rising rates that cause the outperformance, however. Rather, it’s the underlying strong economy that generates profits for these companies. At the same time, several global central banks are raising rates in an effort to offset any inflation that might be creeping up. So while outperformance in certain sectors may coincide with rising rates, the sectors aren’t outperforming because of yield trends.
Who wins?
So who could be the big winners from rising rate s? History would tell us that financial stocks, particularly banks and insurance companies, are one possibility.
One of the ways banks make money is through net interest spread, which is the difference between the rate at which a bank lends and the rate at which it pays interest to customers. As rates decline, the spread narrows. Lending rates tend to follow the downward trend, but the lowest rate a bank can pay in interest to depositors is zero. As interest rates move up, however, banks begin to experience some relief. Lending rates tend to move up faster than rates paid to depositors, allowing the bank to earn more money on every dollar of assets.
Insurers, particularly life insurers, also tend to outperform during periods of rising rates. When you pay a premium to the insurance company, it invests those funds in secure bonds, such as Treasurys. If an insurer derives its payout basis by discounting long-term average rates, it needs to generate strong investment results to cover eventual payouts. Higher rates mean that the insurer can lock up the money at a premium for longer, affording it more profits as opposed to payouts that it has to make.
Who loses?
Rising interest rates can be detrimental, however, to those who depend on a low cost of debt. Bondholders are the hardest hit, since the coupon that they earn is often fixed. As interest rates rise, new bonds pay higher coupons than existing ones, causing the value of the existing bonds to decline. We see this effect in certain equity sectors as well.
Utilities, for example, have typically underperformed as interest rates begin to rise. Investors often view the sector as one that exhibits bond-like returns. Whether the economy is weak or strong, people need to turn on the lights, and so the high dividends that utility companies frequently pay seem relatively secure.
As rates move up, though, the future value of the dividend payments also takes on the characteristics of bonds, which causes a decline in the value of the asset — in this case, the company’s stock. And while it’s true that a utility, unlike a bond, can raise its payout, utilities tend to fund a lot of their capital expenditures with debt. As interest rates rise, new debt payments should rise as well, having a negative effect on cash flows.
Long-term focus helps provide an advantage
While interest rate changes typically affect certain sectors more than others, no two cycles are the same. As such, one potential “trap” for equity investors is to make assumptions that are too broad, expecting short-term shifts in sector leadership that may not play out precisely as expected across the board. Investors can benefit by taking an active view within sectors — analyzing the specific impacts for a particular business or industry in the current cycle.
Maintaining a long-term view beyond the rate cycle also provides important perspective. While mindful of the potential of macro drivers such as interest rates to steer markets both up and down, as managers of concentrated, active portfolios, we remain focused on the power of individual companies to transcend the cycles to which they happen to have some exposure. As such, we seek to be able to perform well in any interest rate environment. We believe that by concentrating on long-term opportunities, we can often add value to our portfolios when short-term volatility occurs. When volatility occurs, or when market leadership shifts due to factors such as changing interest rates, it is important to have comprehensive understanding of both the company’s specific business model and the likely trend for the industry.
Michael Friedman is an associate portfolio manager for the Macquarie Investment Management Global and International Value Equity team, a role he assumed in July 2017. As an associate portfolio manager, he has an active role in assisting in the construction and management of the team’s strategies.
The views expressed represent the Manager's assessment of the market environment as of May 2018 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
© Macquarie Investment Management
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