Let the jockeying begin. Strategists are predicting a major
change in interest rates in 2014 and 2015, and have already begun
to identify the fallout -- positive and negative -- on a wide
range of stocks. As long as you follow the game plan, your
portfolio is likely to benefit.
There are two extremely likely scenarios for 2014. First, the
Federal Reserve is expected to keep the federal funds rate near
zero, which will keep interest rates on shorter-term lending
rates very low. Second, the Fed will ease off its massive
stimulus program (known as quantitative easing, or QE), which is
likely to allow long-term rates to rise to levels that truly
reflect global economic activity. (The QE program has kept a lid
on long-term rates.)
I discussed this notion a few weeks ago
in my look at the soon-to-change yield curve.
Historical trends suggest that certain sectors are likely to
benefit while other sectors are likely to lose some appeal with
investors. And even within sectors, clear winners and losers will
Not All Yield Plays Are The Same
First, let's get the obvious impacts out of the way. Any
income-producing investments such as utilities, real estate
investment trusts (REITs) and master limited partnerships (MLPs)
are bound to suffer. The
SPDR Select Utilities Fund (NYSE:
, for example, has lagged behind the broader market since May,
when investors first sensed that the QE program would soon come
to an end. Look for this trend to continue in 2014.
In a similar vein, the
JPMorgan Alerian MLP Index ETN (NYSE:
, which tracks many of the country's high-yielding pipeline MLPs,
has lagged the S&P 500 Index by more than 15 percentage
points since May.
That doesn't mean that all yield plays will be shunned. As
, companies with rising payouts will still hold appeal. Analysts
at Merrill Lynch concur: "We prefer dividend growth stocks over
simply high dividend yields as a good hedge against rising
rates," they wrote in a June report.
In fact, the steepening yield curve will be great news for any
companies holding significant cash balances. Higher rates should
enable these firms to generate higher interest income,
which I discussed in October
. If you're looking for sectors with lots of cash, then the
tech sector should be your focus. And tech stocks have a
historically positive bias when rates are on the rise, regardless
of cash balances. Merrill Lynch suggests that the 2014 rate
scenario will be very similar to the scenario seen in 1994. Back
then, rates rose higher in tandem with a slowly strengthening
economy, and tech stocks rose 19%, the best gain for any sector.
(Utility stocks fell 17% that year.)
Rising rates have historically been kind to energy stocks as
well. That's because higher rates are often accompanied by higher
rates of inflation, which are often correlated with rising energy
prices. However, this link may not play out in 2014, as inflation
is calmer than a bear in winter.
Know Your Financials
While the playbook for many sectors is cut and dried, the
strategy around bank stocks is more complex. Many banks have a
much greater focus on short-term interest rates, while other
banks are better positioned for moves in longer-term rates.
Right now, a number of banks such as
derive most of their net interest income (that is, the spread
between their borrowing and lending costs) from the spread in
short-term rates. In contrast, many regional banks are structured
to generate most of their net interest income from long-term
bonds. Goldman Sachs cites
Regions Financial (NYSE:
as a clear beneficiary, as more than 60% of net interest income
is derived from the spread between long and short rates.
Among the large banks,
JPMorgan Chase (NYSE:
, with more than 40% exposure to long-term net interest income,
is a Goldman favorite, adding that the bank "has the most
inexpensive valuation in the group on 2014 and 2015 EPS."
To be sure, the housing market stands as either a positive or
negative for banks stocks as well. If rising rates (and higher
mortgage interest rates) start to weigh on home sales, then
profits from mortgage underwriting are bound to slump.
Wells Fargo (NYSE:
Fifth Third Bancorp (Nasdaq:
derive an outsize portion of their business from mortgage
activities and appear most vulnerable to higher mortgage
Then again, these banks have greater upside if the housing
market delivers a better-than-expected performance in 2014. My
take: The recent housing weakness is likely to persist for at
least a few more quarters, but the outlook into 2015 and 2016 is
Risks to Consider:
If longer-term rates don't rise in 2014 in tandem with a
pullback in the QE stimulus program, then investors will grow
concerned that the U.S. economy remains distressingly weak.
That's a negative scenario for the potential beneficiaries noted
above and likely a positive for more defensive stocks such as
utilities and MLPs.
Action to Take -->
It's quite likely that the Fed will start tapering the QE program
in the next three to four months -- if not sooner -- and you need
to adjust your portfolio in advance. Stress-testing each
portfolio holding in terms of interest rate sensitivity is an
exercise you should begin soon, if you haven't already.
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