Yahoo Finance Where to Find Opportunity When Monetary Policy Tightens
All indications show that the Federal Reserve will raise interest rates this year -- Chairman Janet Yellen specified as much in a speech she gave at the University of Massachusetts Amherst on Sept. 24.
The historical purpose of raising interest rates is to cool down an overheated economy by raising the cost of money. This time we are not really faced with a robust economy, but the Fed does desire to bring rates back to a more "normal" level.
I believe that even though the Fed has not yet raised rates, monetary policy is getting tighter, mainly due to the dollar getting stronger. The stock market has started to discount the tighter monetary conditions even though rates have not been officially hiked. So the question becomes: Is there any insight to be gained from history, when it comes to finding opportunity during tightening cycles?
Historically, stocks have behaved differently when the Fed has raised interest rates quickly, such as in 1987, 1994 and 2004, versus gradually (1963 and 1977). Consider these examples:
-- When the Fed raised rates rapidly in the past, stocks sold off shortly after the first rate hike. During more gradual cycles, stocks continued to rise several months past the initial hike and showed gains 12 months later.
-- Absent a recession, periods of market declines during the first year of a tightening cycle have been buying opportunities. The median return of the Standard & Poor's 500 index one year after the start of a cycle is 6.5 percent. When tightening has been slow, the returns are even better, with a median return one year later of 17.4 percent.
In today's environment, I believe rates will hike in a slow cycle. There is no inflation that is discernable on the horizon -- the Fed will only be trying to move out of their stance of extraordinary monetary easing. Information provided by the Federal Open Market Committee indicates a likely path will be a 0.25 percent rate hike every other meeting, or about 1 percent over the next year.
For this cycle, I favor defensive consumer sectors, such as health care and consumer staples. If the Fed starts raising rates, it will likely mean that the dollar will continue to strengthen; accordingly, looking for industries with high cash levels and positive sensitivity to the dollar can provide a macro tailwind.
The health care sector has been beaten down during the current correction and could offer an attractive entry point. Earnings estimates and sales growth for 2016 remain above those for the S&P 500. The health care sector will continue to benefit from the aging population and the Affordable Care Act.
Consumer staples does not offer the level of growth provided by health care, but it should offer more stability and dividend yield. Although a number of multinational companies are part of this sector, it has shown positive sensitivity to the dollar, likely due to the weakness of commodity prices. For earnings reported for the second quarter of this year, the consumer staples sector showed the highest percentage of companies with positive earnings surprises at around 77 percent.
Investors can play either sector using a sector specific exchange-traded fund. If you are interested in individual health care companies, I suggest you consider UnitedHealth Group (UNH). UnitedHealth's approximately 45 million members give it the ability to scale its fixed costs and maintain pricing leverage. In the consumer staples area, take a look at Kroger Co. (KR). I believe its valuation and earnings growth will benefit over the next 12 months, mainly from the company's position as the largest U.S. traditional supermarket operator in an improving domestic economy.
As of this writing, neither Bob Phillips, his firm nor the firm's clients held a position in these companies.
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