Equity-Sector Leadership Can Shift Amid Rising Interest Rates
In an environment in which interest rates have been steadily rising — the 10-year US Treasury yield has moved up almost 75 basis points since its recent low in September 2017 — one question that investors face is the potential effect of this phenomenon on equity sectors. Which sectors might be winners or losers in a rising rate environment?
The answers to this question could, at first blush, seem fundamental or textbook. Close consideration of the factors at play in a rising-rate environment, however, shows that stock price movements related to rate changes may be nuanced and can vary from cycle to cycle. For these reasons, an active investment approach can be essential to evaluate the impacts of interest rates and to identify resulting opportunities.
Interestingly, while some sectors may be expected to outperform during periods of rising rates, that performance success is often a result of correlation to the rate movements rather than causation.
As one example, industrial stocks often do well as rates move up. It’s not the rising rates that cause the outperformance, however. Rather, it’s the underlying strong economy that generates profits for these companies. At the same time, several global central banks are raising rates in an effort to offset any inflation that might be creeping up. So while outperformance in certain sectors may coincide with rising rates, the sectors aren’t outperforming because of yield trends.
So who could be the big winners from rising rate s? History would tell us that financial stocks, particularly banks and insurance companies, are one possibility.
One of the ways banks make money is through net interest spread, which is the difference between the rate at which a bank lends and the rate at which it pays interest to customers. As rates decline, the spread narrows. Lending rates tend to follow the downward trend, but the lowest rate a bank can pay in interest to depositors is zero. As interest rates move up, however, banks begin to experience some relief. Lending rates tend to move up faster than rates paid to depositors, allowing the bank to earn more money on every dollar of assets.
Insurers, particularly life insurers, also tend to outperform during periods of rising rates. When you pay a premium to the insurance company, it invests those funds in secure bonds, such as Treasurys. If an insurer derives its payout basis by discounting long-term average rates, it needs to generate strong investment results to cover eventual payouts. Higher rates mean that the insurer can lock up the money at a premium for longer, affording it more profits as opposed to payouts that it has to make.