What Stock To Buy When Interest Rates Rise? When it became clear that COVID-19 was spreading in the United States, local and state governments responded quickly. Stay-at-home orders went into effect, businesses were closed, and many economic activities came to a screeching halt.
The sheer shock of those unprecedented moves sent the market into a tailspin, resulting in a series of crashes. The largest occurred on March 16, 2020, when most global markets dropped between 12 percent and 13 percent in a single day.
Fast action kept the March decline from becoming a long-term crisis. One of the most effective moves came from the Federal Reserve, which reduced the federal funds rate to almost zero. That, coupled with comprehensive government stimulus programs, prevented substantial economic damage. By April 2020, the markets were already recovering.
Of course, that isn’t to say that by April 2020, there was no risk of recession. For the remainder of the year and into 2021, rates remained low, and more government stimulus was added. The Federal Open Market Committee, which makes decisions on interest rate changes, indicated that there was no plan to increase the federal funds rate before 2024.
However, low interest rates and high levels of government spending come with a dark side: inflation. By the end of 2021’s second quarter, it became clear that consumer prices were going up rapidly. In March 2021, the Fed projected total inflation at approximately 2.4 percent. By June, the committee increased its prediction to 3.4 percent.
With that in mind, it appears interest rate increases may come before 2024. For the moment, most expect to see rates go up in 2023, but further issues with inflation may compress that timeline even more. Some analysts predict that the first interest rate increases will come by mid-2022. That brings up an important question for investors: what stock to buy when interest rates rise?
What Happens To Stocks When Interest Rates Rise?
When interest rates rise, it is more expensive to borrow money, and that’s a big deal for the businesses that trade their shares on public exchanges. Most industries find that their interest expenses go up, which has a dampening effect on bottom-line profits.
It takes some time for interest rate changes to become visible in the profits of publicly traded companies, but that doesn’t stop investors from reacting to news of interest rate hikes immediately. In most cases, when interest rates rise, share prices go down – though there are exceptions.
What Sectors Perform Well When Interest Rates Rise?
Some sectors see an increase in profits when interest rates go up. The biggest winners are companies in the financial services industry. Consider traditional banks, for example. They take in deposits, pay interest to depositors, and then lend those funds to borrowers. The borrowers pay interest to the bank at a higher rate than the bank is paying to depositors.
The difference between the interest banks receive from borrowers and the interest they pay to depositors is referred to as the “spread” – and the spread is where banks make their profit.
As interest rates go up, banks can charge borrowers more. They might pay depositors a bit more, too, but the increase in interest paid to depositors is rarely equal to the increase in interest charged to borrowers. That means bigger profits, which translates into shareholder returns.
What Stocks Are Sensitive To Interest Rates?
Some industries experience a decrease in share prices when interest rates go up – and that’s not just because they are paying more on their own debt. Those that pay higher-than-average dividends, for example utility companies, often see their stock prices drop.
Industries that rely on consumers having disposable income and access to credit, such as retailers, find that Interest rate changes have a more complicated – and less predictable – effect on share prices.
On the one hand, consumers are paying more interest, which means they have less disposable income. In addition, high interest rates may discourage them from borrowing to make large purchases. That can drive sales down in sectors like real estate. On the other hand, increased rates correspond to a growing economy, which can make consumers more confident in making discretionary and large purchases.
In other words, there is a fragile balance when it comes to consumer behavior during periods of rising interest rates. Most stocks do well at the point where consumers have confidence in the economy, but interest rates haven’t gone so high as to make borrowing unappealing.
During this period, determining specific stocks that are likely to drop in price as the result of interest rate increases can depend more on the overall health of the company than interest rate trends.
What Stock To Buy When Interest Rates Rise?
Rising interest rates signal that financial services companies are likely to see increased stock prices.
Brokerage firms that are poised to do well when interest rates rise include Charles Schwab, E-Trade, and TD Ameritrade.
Along the same lines, insurance companies can be smart stocks to buy when interest rates rise, as they see greater returns from their underlying bond investments. In this space, investors often choose Allstate, AmTrust, Markel, MetLife, UnitedHealth (UNH), and the Travelers Companies.
When considering what stock to buy when interest rates rise, don’t trade based on the sector alone. Simply belonging to a specific industry isn’t enough to put the shares on your short-list.
Examine the underlying strength of the company, including its management team, its financial statements, and any external headwinds that could adversely impact returns before adding a specific stock to your portfolio.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.