Interest rates are still historically low in the U.S., but they are bound to rise—at least according to signals from the Federal Reserve. When they do begin to rise, different economic sectors will react in different ways because they display various correlations to rates.
To investors, that means a changing opportunity set in a rising-rate environment, and Nick Kalivas, senior equity product strategist at Invesco PowerShares, gave us a rundown of where he sees those opportunities for sector-focused investors.
ETF.com: Should the outlook of higher rates ahead impact how investors go about sector investing?
Nick Kalivas: Yes, rising rates tend to signal stronger economic conditions and can impact sector returns. Higher rates are usually consistent with stronger economic growth and inflationary pressures, and sector performance can be influenced by trends in growth and inflation. For example, Industrials, financials and cyclical names can benefit.
ETF.com: What sectors are most highly correlated to interest rates, and why?
Kalivas: Looking at correlations, industrials, materials, energy and financials display the strongest correlation to rising 10-year Treasury yields. In contrast, utilities, telecom, consumer staples and health care show weak correlation.
Cyclical sectors like energy, industrials, information technology and materials have historically shown the strongest correlations to interest rates. This makes sense given that inflationary pressures and higher interest rates often come on the heels of strong economic growth—the same growth that benefits economically sensitive sectors. A strong economy is likely to boost capital spending, which should bode well for IT shares. However, one of the challenges facing the energy sector is a near-term glut in crude oil supply.
Financials also show strong correlation to the 10-year Treasury yield—with the relationship particularly close over the past five years. Given the zero-interest-rate environment we’ve seen since 2008, net interest margins (the difference between interest income that financial institutions generate and the interest they pay to lenders) have been depressed. Correspondingly, net interest margins should benefit from higher interest rates. Many market participants realize this and have pushed bank shares—as defined by the KBW Bank Index—above their one-year trading range in recent days. In my view, it’s definitely a good time to own bank stocks.
Consumer discretionary shares have also gained during periods of rising interest rates, although the correlation is not nearly as strong as with financials.
As you might expect, defensive sectors like consumer staples, telecommunication services and health care have demonstrated tepid correlation to rising interest rates. And there is the performance of industries underlying these sectors. Within health care, biotech is a particularly crowded field, and has shown a negative correlation to interest rates. It would not be surprising to see defensive sectors underperform more economically cyclical sectors when rates go higher.
At the back of the pack is utilities, which has shown an inverse correlation to 10-year Treasury yields over the past five years. Utility company issues are among the worst-performing components of the S&P 500 Index so far in 2015. Reflecting their underlying indexes, many exchanged-traded funds with dynamic sector allocation, including the PowerShares S&P 500 Low Volatility Fund (SPLV | A-60), have significantly reduced their exposure to utilities over the past two years, at the same time that many investors have been anticipating higher interest rates.