In March, the Federal Reserve set into motion a cycle of rate hikes that could last well into 2023. That's bad news for borrowers—but could be good news for sectors that historically have benefited from higher interest rates.
Timing is everything
Although rate-hike cycles generally result in greater market volatility, research has shown that the pace at which the Fed raises rates can produce different outcomes:
- When the Fed takes a slow approach, meaning it doesn't raise rates at consecutive policy-setting meetings, the stock market has tended to do well in the months following a new cycle.
- When the Fed takes a fast approach, raising interest rates at nearly every policy-setting meeting, stocks historically have struggled.
The market expects the Fed to raise rates at each of the remaining policy-setting meetings in 2022 and anticipates additional hikes1 by the end of 2023—which suggests stocks may be in for a bumpy ride, at least in the near term.
Looking back at past cycles, we've found that certain sectors generally respond favorably to rising interest rates, while others respond more neutrally or even suffer.
- Communication Services, Health Care, and Utilities sectors tend to see a boost as heightened volatility drives investors toward stabler options. Be aware, however, that Communication Services has undergone some big changes in recent years—when stocks such as Amazon, Alphabet, and Netflix were added to the sector—so historical performance might be less relevant.
- Energy stocks are supported by higher oil prices—which help drive up inflation, a key factor in the Fed's interest rate policy. Despite historical trends, however, tread carefully in this sector. The price of oil—the primary driver of its performance—is fickle and prone to unpredictable geopolitics.
- Financials tends to profit from rising interest rates as banks and other lenders raise rates on borrowers. Typically, longer-term interest rates rise as the Fed starts hiking rates due to the strong growth that is stoking inflation. However, if the Fed has to act forcefully to tamp down inflation—which raises concerns about economic growth—Financials could take a hit.
- Information Technology is a high-growth sector with little direct exposure to interest rates—rather, it's driven more by business investment. That said, the sector typically performs well in the early months of a rate-hike cycle before higher rates have had time to cool things down.
- Consumer Discretionary, Industrials, and Materials stocks tend to underperform during rate-hike cycles as investors anticipate that higher inflation and borrowing costs will begin to undercut business and consumer spending.
- Consumer Staples, while defensive in nature, can face shrinking profit margins in an inflationary environment without the pricing power to offset higher costs.
- Real Estate, which consists primarily of real estate investment trusts (REITs), is a mixed bag. REITs tend to benefit from economic growth, which supports rent collections and property prices; but most REITs borrow heavily, making them extremely vulnerable to rising interest rates.
Historically, six of the 11 market sectors have outperformed the broader market in the year following an initial rate increase: Communication Services, Energy, Financials, Health Care, Information Technology, and Utilities. The other five sectors fared less well, with Real Estate performing the worst.
Winners and losers
Source: Charles Schwab, Ned Davis Research.
Median S&P 500 Index sector performance relative to the S&P 500 12 months after the first rate hike of the federal funds target by the Federal Open Market Committee over the past five rate hike cycles beginning: 02/04/1994, 03/25/1997, 06/30/1999, 06/30/2004, and 12/16/2015. Real Estate is represented by the FTSE NAREIT Total Return Index, as Real Estate did not become a separate Global Industry Classification Standard (GICS®) sector until 2016. Data as of 01/03/2022. Past performance is no guarantee of future results.
Easy does it
While there may be potential opportunities in those sectors that have historically outperformed as the Fed began hiking interest rates, sector leadership is likely to be very erratic as the Fed works to force back the strong surge in inflation. If you do make adjustments to your sector allocations, consider keeping them small—no more than a few percentage points.
1Market expectations of future rate hikes are derived from federal funds futures for December 2022, 2023, and 2024.
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