The cat-and-mouse game between Wall Street and the Federal Reserve continued this week, with the Fed minutes from the central bank's April policy meeting showing that a lending rate hike in June may very well be on the table.
The Fed went into 2016 planning to lift rates four times during the course of the year, with an intermediate-term target fed funds rate of 2%. That went out the window when Q4 GDP underperformed, and recent Q1 data showed economic expansion of just 0.5%. Nonetheless, the U.S. labor market tells a vastly different story, with the unemployment rate holding firm at 5% as of April, down 50% from the unemployment rate peak of the Great Recession in Oct. 2009.
Three types of stocks to own when interest rates rise
Monetary tightening from the Fed often brings mixed emotions to Wall Street. On one hand, tightening only comes about because the Fed is trying to keep the U.S. economy from overheating. This would imply that the jobs market and overall economy are in pretty good shape, suggesting corporate America is doing just fine. On the other hand, monetary tightening makes it more expensive to borrow, which can crush M&A activity and stymie loans, harming corporate expansion efforts and stifling future growth prospects.
So what's an investor to do? With the Fed expected to embark on a new round of monetary tightening, my suggestion is to consider buying three types of stocks.
If there's a group of stocks that tends to benefit the most from increasing interest rates, it's the financial sector.
Bank of America (BAC 1.38%), for example, announced last year that a 100-basis point increase in short- and long-term rates would equate to an additional $4.6 billion in annual net interest income, or up to a $0.43 per share boost in annual EPS. Money center banks like Bank of America are likely to see their net interest margins expand if lending rates rise, which allows banks to charge more for loans, as well as boost variable rates for existing loans. Considering that Bank of America has one of the lowest returns on assets among its peers, it could be among the biggest beneficiaries of a rate increase, with its share price still depressed on a tangible book value basis.
But don't forget about financial stocks that pool their money, such as insurers and payroll processing companies. Insurer Allstate (ALL 3.13%) ended its latest quarter with $106 billion in total assets, of which $57.3 billion was invested in fixed income securities. Because this money needs to be available for claims, insurers like Allstate typically buy extremely safe investments like bonds. As rates rise, investment income on this $57 billion can climb too, potentially adding more than $1 billion in extra investment income to Allstate's bottom line, annually, in the coming years.
Payroll processors like Paychex (PAYX 2.19%) operate similarly. Wages received from clients are often held for a short period of time before being distributed to employees, with payroll processors like Paychex earning interest on the short-term float and padding their pockets. The higher interest rates climb, the more a company like Paychex can make on its float. As of the end of its fiscal third quarter, Paychex held average investment balances of $4.52 billion for clients and $827 million in corporate investments, with an average earned rate of just 1%.
Cash-rich technology stocks
Select technology companies that are carrying around healthy net cash balances should also fare pretty darn well in a rising rate environment, for two key reasons.
The first, as you may have surmised, is that having a large cash pile means the opportunity to earn more in interest via short- and long-term investments. This isn't to say tech companies are going to be running out to buy U.S. Treasury bonds if rates lift a quarter point come June, but it's going to give companies like Microsoft (MSFT 1.07%), which has generated in excess of $31 billion in operating cash flow over the trailing 12-month period, the opportunity to park its cash somewhere that can earn it reasonable income. Yes, Microsoft is carrying almost $47 billion in debt, but it still maintains a net cash balance of nearly $59 billion. A lot of big tech companies are like Microsoft, in that they aren't reliant on debt to finance their growth, which could mean far less of an adverse impact when rate hikes occur. Plus, the added investment income could be returned to investors in the form of a dividend hike.
The other factor working in cash-rich tech stocks' favor is that the U.S. economy is relatively healthy. Although Q1 GDP may not show it, rates expand only when the Fed believes the economy is marching forward -- and if the economy is improving, that could mean more money being spent on software and gadgets.
Consumer discretionary stocks
Finally, a surprising category of stocks that can actually perform pretty well when rates are rising are consumer discretionary stocks, or companies that sell non-essential items. We're talking about apparel, service, and media companies, to name a few examples.
Why consumer discretionary companies? Although they tend to have more debt than the large tech stocks discussed above, consumer discretionary companies are more adept at taking advantage of a robust economy. Again, notwithstanding the anemic Q1 GDP growth of 0.5%, the Fed wouldn't be raising lending rates if it didn't see a number of U.S. economic parameters improving. If rates are rising, it would presumably mean that the consumer is out there spending their money somewhere; and what better way to take advantage of that than with consumer discretionary stocks.
An example I like to fall back on here is Starbucks (SBUX 3.76%). Consumers already have a strong bond to Starbucks (this is coming from a 20-year Starbucks addict), and Starbucks' loyalty rewards program, which rewards consumers with free beverages based on their spending habits, is another reason why consumers stick with the brand. If the economy is improving, consumers aren't likely to give up that afternoon frappuccino, choosing instead to make their daily drink a small luxury or indulgence. And Starbucks knows this, which is why it received a 5% same-store boost in the Americas in its fiscal second quarter because of price increases. A solid discretionary company like Starbucks should do just fine in a rising rate environment.
What companies are on your radar when rates rise? Share them in the comments below.