"When rates are high, stocks will die, and when rates are low, stocks will grow."
I'll never forget hearing this at a stock market seminar when I was around 12 years old. Taken to the symposium by my investor grandfather, this was my first actual exposure to stock market wisdom. These were the days of 17%-plus interest rates and some Fidelity mutual funds posting massive returns of over 25%!
If someone had predicted rates near zero less than a generation in the future, they would have been laughed out of the room. However, the impossible has now happened, with rates pushed to zero in a valiant effort to save the U.S. economy.
Fast forward to the early part of 2018 and the low rates and massive quantitative easing measures have worked their magic, with the stock market making record high after record high. Now, with the economy potentially going into overdrive, the Fed has slowly started to bump up rates. Rates have begun to climb with up to four increases possible for this year.
Will the old saying about stocks dying when rates climb pan out this year? Does the rate rise regime mean the bull market will soon be coming to an end?
Like most stock market wisdom, the common belief of rising rates killing stocks is not quite true. In fact, rising rates are a double-edged sword.
On one hand, climbing rates make it more costly for firms to borrow, adding friction to growth. The other side of the equation is that rising rates signal that the economy is expanding bullishly.
Evidence seems to suggest that as long as there are no rate increase surprises, a well-managed program of increases has little to no effect on the overall market.
In fact, there are specific sectors and companies that benefit from climbing rates. Nearly every investor knows that financial firms profit from higher rates. However, there are other ways some non-financial companies directly benefit from higher rates.
I have identified three non-financial companies that will significantly benefit from these increases.
1. Xerox (NYSE: XRX )
Falling off its highs to below support at the 50- and 200-day simple moving averages (SMAs), the original digital print company is higher by under 3% in 2018. However, due to the way the company's pension plan is structured, it stands to benefit significantly from climbing rates. Let me explain.
A report by Zion Research discovered companies whose estimated pension-related interest rate exposure is at least 59% of their stock's market capitalization. Increasing rates are great for these firms since higher rates lower the present value of the company's obligations in the pension.
I know this may seem complicated, but it's straightforward. Increased interest rates mean that the company needs to allocate fewer assets to fund the pension needs. In turn, this can lift earnings and the stock price.
A financially healthier pension will improve the balance sheet, cash flows, and earnings since there are lower costs associated with retirement funds.
Zion's study identified those companies taking on the most interest rate risk and where there is a disconnect between the asset duration of the pension plan and its required payouts. Xerox emerged as one of the companies that can benefit from higher rates.
Broken down into rough numbers, Xerox has nearly $11 billion in pension obligations and just over $5 billion in fixed income assets. Its net interest rate exposure is close to $6 billion, creating a net interest rate exposure as a percentage of the market cap of 72%. Xerox is second only to General Motors in the interest rate exposure as a percentage of market cap metric. General Motors boasts a 78% exposure, but right now I think Xerox is a smarter buy.
I recommend waiting for a breakout above the 200-day SMA and buying at $31.50 per share.
2. Apple (Nasdaq: AAPL )
Shares of the tech giant have roared back to the highs after suffering a steep selloff from January to February 12.
The reason rising rates will significantly benefit Apple is three-fold. First, the higher rates will increase investment yields. Firms with vast cash hoards to invest will gain from the stronger investment returns. Apple boasts an extremely high overseas cash hoard of around $230 billion. As the company starts to repatriate this massive amount of cash, it will benefit as higher rates increase domestic investment yields.
Secondly, slowly increasing rates signal an improving economy. An improving economy means more customers are buying a higher number of Apple products over time.
Thirdly, climbing rates will increase the dollar's buying power, lowering Apple's imported part cost from foreign factories -- provided all else remains equal.
Add in the coming tax reform benefits and an extremely bullish picture emerges for Apple.
Right now, Apple is a momentum trader's dream stock. Getting long on a breakout of $182.00 per share makes solid technical sense.
3. Caterpillar (NYSE: CAT )
Research by CNBC identified stocks that performed best during periods of climbing rates. Beyond the expected financial stocks, such as Goldman Sachs and J.P. Morgan Chase, Caterpillar posted the fifth-best performance of Dow Jones Industrial components in times of increasing interest rates.
Buying a breakout above the 50-day SMA at $160.00 per share makes sense as a momentum buy going into the higher rate period.
Risks To Consider: The above bullish thesis assumes a period of gently increasing rates with no Fed surprises and all else remaining equal. Stocks hate surprises, particularly of the interest rate increase variety, therefore a surprise rate hike will likely send shares sharply lower.
Action To Take : Add the above stocks to your "interest rate" bullish watch list to potentially add to your long-term portfolio as interest rates gently climb.
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