Look around and you'll see a familiar prediction from just about every economist and financial publication: The Federal Reserve is poised to raise interest rates in 2015.
The idea itself isn't all that far-fetched. U.S. GDP surged by 5% in the third quarter and most signs, including a vastly improved jobs market, would appear to indicate that the U.S. economy is only getting stronger. A short-term hike in lending rates very well could be a reality in 2015.
With this in mind, we asked three of our top analysts to name a top stock they'd consider a great buy if the Federal Reserve did decide to raise rates in 2015. Here's what they had to say.
Most investors worry that higher rates from the Fed will end the bull market in stocks, but some sectors actually benefit from rising rates. One of those industries is the insurance business, and insurance giant and Dow component Travelers (NYSE:TRV) could see substantial improvements in its earnings if rates start to rise.
Insurance companies generally hold fixed-income securities as investments in order to generate income on the float that they hold. In other words, when Travelers collects premiums from policyholders, there's a lag before the company has to pay out on any losses arising from those insurance policies. Travelers can use the resulting investment income to help it pay claims and boost its profits. Yet when interest rates are low, the investments that Travelers makes don't pay as much income, and so it can't profit as much from its float. When rates rise, so too will the income that Travelers earns on its investment portfolio.
Travelers has also enjoyed unusually low losses in recent years, as the industry environment after Hurricane Sandy allowed insurance companies to raise premiums even as storm activity fell dramatically. Travelers won't avoid losses forever, but higher rates could help it weather any financial storms a lot more easily.
Banks with strong lending operations can benefit from a rising-rate environment, and one of my favorites is Wells Fargo (NYSE:WFC), which is the nation's top mortgage lender and doesn't rely on some of the "risky" revenue streams that other banks depend on. In fact, Wells Fargo's business model looks more like a traditional savings and loan than one of the biggest financial institutions in the country. In other words, the bank is much more focused on activities such as community banking and not on investment banking and trading, unlike most of its similarly-sized peers.
Additionally, Wells Fargo has better asset quality than many of its peers thanks to its generally conservative lending strategies, and it keeps getting even better. The bank has a net charge-off rate (bad debt) of just 0.34% (Bank of America's is 0.40% by comparison), and the dollar amount of charge-offs is down 18% from just a year ago.
Banks benefit from rising rates in several ways, but one big reason banks with large lending operations like Wells Fargo will do well as rates rise is that the spread between the amount of interest they have to pay depositors tends to widen as rates rise.
Just as one example, consider that the current average 30-year mortgage rate is 3.66%, and the average savings account interest rate is just 0.06%, according to FDIC data. So, if you deposit money and the bank lends it out, the bank's profit is the 3.6% difference between those two rates. Typically, as mortgage interest rates rise, banks are able to reap bigger profits as the difference increases.
Of course, this is a simplified example, but if you agree with the experts who say rates will finally begin to rise this year, it may be a good time to take a look at Wells Fargo for your portfolio.
Following robust dividend growth of 5% in the third quarter, the Federal Reserve certainly has enough reasons on the table to consider cooling down the economy with a short-term rate hike before things get out of hand. If an interest rate hike were to happen as many economists have predicted in 2015, Automatic Data Processing (NASDAQ:ADP), or ADP, is a company I'd consider a strong buy.
First, the Federal Reserve would only raise its federal funds target for one reason: It believes the U.S. economy is capable of standing on its own two feet once again. If the economy has improved, then it's likely that the job market is going to remain healthy as well. More jobs being created means more payroll service dollars for ADP, the largest payroll processing company.
More importantly, higher interest rates could mean millions more in interest income for payroll processors like ADP. Payroll processors receive funds from clients and often hold these funds for a few days before cutting employees a check. This hold time allows payroll processors like ADP to earn interest on the cash floating in its account. Best of all, ADP doesn't have to return this earned interest to its clients or the employees. As you might imagine, lower interest rates have squashed its interest-earning ability on this float. However, in 2008 ADP earned nearly $700 million this way, which would equal about $1.45 in extra earnings per share per year if rates returned to those early 2008 levels.