Stocks to Avoid when the Fed Tightens

The Fed raised the short term Federal Funds rate by a quarter point on Wednesday. Additionally, they dropped language indicating that their current stance would be “accommodative”.  This will have ripples throughout the economy and more importantly the markets.
 

The Federal Funds rate is the overnight bank rate at which banks loan money to each other. It is the most important benchmark from  which other short term rates are set. The Fed controls this rate and uses it as a lever to control the economy.

The Fed has been raising rates over the past two years. This serves to slow the economy down, and avoid overheating. This helps to keep a lid on inflation, which the Fed views as anathema to long term economic growth.

These gradual quarter point increases have taken short term rates from essentially zero to now 2.25%. The changes have been made at such a gradual pace that it hasn’t yet upset the economic apple cart. There is worry, however,  that the cumulative effect could start to build up. Fed increases tend to have a very long lag from when the Fed increases rates to when it slows the economy.

 

Utilities are off

Given that the Fed is signalling that these rate increases are continuing it is time to examine the market and prune some  interest rate sensitive holdings that could be exposed. Additionally other interest rate sensitive industries such as Utilities, Autos and Energy stocks are probably in for a rough ride. Why? In general, they pay higher dividends than other companies. Investors often buy them to get the yield, but if risk free treasuries are also paying a reasonable rate, they may opt for safety.
 

Export Sensitive Industries

Another dampening factor that is caused by the fed rate rise is that increasing rates typically will inflate the value of the dollar. The dollar will be viewed in global markets as a more stable currency, and the yields will entice foreign investment. As foreign investment comes into the country, they buy dollars, and this causes the exchange rate to rise.
 

This could not happen at a worse time. Take a firm like Caterpillar. Not only are they struggling with the raging tariff wars, they now have increasing prices overseas to compensate for the rising dollar. This double whammy will definitely impact foreign sales. The same could be true for Archer Daniels and other Ag firms.

 

The Fed Rate Increase Bright Spots:

So who benefits from the increasing interest rates?  
 

Banks:

Banks can increase the amounts that they charge their clients without fully passing the increased rates onto the savers This is called Net Interest Margin, and it typically increases as the Fed raises rates, which fattens bank profits. Focus on domestic vs. large international banks for the biggest impacts. As you can see from the chart below, the Margin has been increasing as the Fed raises rates, and now it looks like this trend will accelerate. Look to the regional banks as the big winners.
 
Hong Kong Stock Exchange
 

Consumer Discretionary:

The Fed raises interest rates because the economy is in danger of overheating. Of particular concern, employment is reaching “full employment” in their eyes. Obviously robust employment and wage growth is great for the consumer, and can lead to additional spending.  With extra money, the consumer can spend on non-essential or discretionary items. The Fed would not increase rates without a strong economy, and Consumer Discretionary stocks tend to benefit from the increased money in consumers pockets.
 
 

Summary:

While this interest rate move by the Fed has long been anticipated. The markets reaction was immediate and negative. Stocks went from trading in positive territory to showing a loss for the day. As the rate increase flows through the economy, there will be winner and losers in the market. If, as expected, the Fed continues to raise rates, many stocks will face headwinds as they struggle to cope with increased rates, increased dollar exchange rates and other negative impacts. The smart investor will try to get ahead of these moves.

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