Companies making products people will still buy even when they have less money to spend are a good bet when rates are rising. Above, Procter & Gamble Puffs tissues.
Tiffany Hagler-Geard/Bloomberg
The Federal Reserve is on the doorstep of raising interest rates many times. That means it is time for technology, classically defensive, and quality stocks to shine.
Inflation is the worst since the early 1980s and is just a touch below what is likely to have been the peak, so the Fed is expected to lift short-term interest rates at least four times this year. That could help bring down yields on long-dated bonds because higher short-term rates are designed to curb economic demand, lowering the inflation rate for the longer term. Expectations for inflation have driven long-term yields higher.
That makes a big difference for technology stocks. If long-dated bond yields rise slowly—or even fall—that would be good for tech valuations because lower yields boost the discounted current value of future profits. Many tech companies are valued on the basis of the profits that they are expected to bring in years from now, rather than what they are generating now.
Indeed, 12 months after the first rise in rates in a new cycle of increases, S&P 500 tech stocks have outperformed the broader index by 13 percentage points, on average, dating back to 1994, according to Evercore data.
The same could apply to tech stocks today. The tech-heavy Nasdaq is already down 13% from its Nov. 19 all-time high as the 10 year Treasury yield has soared. It could be time to buy the dip, though there could be more pain in the short term.
Classically defensive stocks—those of companies selling goods and services that remain in high demand even when consumers and businesses have less money to spend—are also usually good bets when the Fed starts lifting rates. Utility, real estate and healthcare stocks in the S&P 500 have outperformed the broader index by 4, 7, and 2 percentage points, respectively, in the 12 months following an initial rate increase since 1994, on average.
Quality stocks, regardless of sector, are another area to focus on. Those companies have stable cash flows, either because they are in defensive sectors, or because they’re well-established and highly competitive. They usually have large balance sheets with minimal debt.
Companies with light debt burdens often don’t see a significant spike in the interest rate on their existing bonds when rates rise, which enables their valuations to remain relatively high. Quality stocks on the S&P 500 have historically outpaced the broader index by 3 percentage points in the year after an initial rate increase.
“Tightening financial conditions are a tailwind to quality of earnings,” wrote Dennis DeBusschere, founder of 22VResearch. Just get in on these stocks before investors bid their prices upward.
Write to Jacob Sonenshine at [email protected]
