What Sectors To Own When Rates Rise

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.

ETF.com: Do you anticipate a pickup in demand for, say, cyclical stocks when rates do begin to rise? Is that where investor money is going to flow?

Kalivas: Yes and yes; I think higher rates would be consistent with stronger economic growth, and the environment would be consistent with improved profitability of cyclical shares. There is a robust relationship between the growth in industrial production and the direction of the 10-year yield, so higher rates would likely signal an upswing in production growth and improved profitability in cyclical sectors.

I would expect money to flow where the earnings growth is present. In recent months, cyclicals have been hurt by the slowdown in industrial production—lagged impact of a strong dollar, inventory overhang, fall-out from low commodity prices, and weak emerging market economies. These factors have also pressured Treasury yields.

ETF.com: From a performance standpoint, will different sectors perform differently in a rising-rate environment after years of ultra-low rates? In broad terms, higher rates are good for stock returns, right?

Kalivas: I don’t believe ultra-low rates will change the impact, and higher rates would likely be consistent with improved stock returns. The direction in rates signals underlying economic trends. The unusually low rate environment has been consistent with unusually low growth. Nominal GDP growth has been unusually low in the post-crisis period and has been a factor leading to unusually low rates. Nominal GDP has been below 5 percent post-crisis, and was well over 5 percent in most periods after World War II. Stronger growth will improve the outlook for cyclical names.

It’s possible that there’s a period of hiccup and dislocation as the Fed starts to raise rates—this occurred in the 1994 period. However, usually, stocks perform well through much of the rate-hike cycle. The start and end can be riskier.

ETF.com: What’s the best way to implement a sector rotation strategy in a rising-rate environment?

Kalivas: It’s really up to the investor to find a mechanism for gaining sector exposure. When looking at a sector rotation strategy, investors should be looking at methodologies that are unemotional, capable of capturing trends and able to manage risk.

One of our business partners, Dorsey, Wright and Associates, runs three models based on underlying PowerShares ETFs that are sector rotation strategies. The methodologies use momentum to select the strongest-performing sectors/industries on the basis of relative strength. To the extent that rising rates start impacting sector performance, these models would be expected to pick up on the trend and the macro environment’s impact would filter into the suggested model holdings.

Contact Cinthia Murphy at [email protected].