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Rate Hikes and Stocks: A Hit List

By Beth Piskora From Standard & Poor's MarketScope

The Federal Reserve's decision on Sept. 20 to raise the Fed funds target rate by a quarter-point, to 3.75%, appears to signal that the central bank isn't overly concerned that the devastation caused by Hurricane Katrina in the Gulf Coast region will slow down economic growth throughout the country (see BW Online, 9/21/05, "The Fed Looks Past Katrina").

Certainly, the recent jump in gasoline prices, the resulting decline in consumer sentiment, the increasing likelihood for at least a near-term slowdown in real gross domestic product growth, and the surge in local joblessness as a result of Hurricane Katrina were considerations that might have led the Fed to leave rates untouched, notes Sam Stovall, chief investment strategist at S&P.

But the tone of the recently released minutes of the July Federal Open Market Committee meeting, combined with the statement that accompanied the Sept. 20 rate hike, indicate, in S&P's view, that the Fed chose to raise rates because it believes these negative effects won't be long-lasting.

"As a result, the Fed wishes to remain vigilant to a future pickup in inflation, due to increasing fuel-related production and transportation costs, along with consumers' willingness to accept price increases," says Stovall.

BANKING ON IT. Despite some speculation in the market that the Fed would pause in its cycle of rate hikes, S&P Chief Economist David Wyss firmly believes the policy tightening would continue. He has, however, changed his yearend forecast. "We now expect the Fed to stop tightening at 4% rather than 4.25%, but that remains a best guess at this time and clearly depends on the monthly data and the continued reports on hurricane damage," Wyss says.

In this environment, how could key equity sectors fare? Financial-services stocks are generally thought of as the most sensitive to interest rates. "I think the reaction to a rate hike among the larger banks will be moderately negative," says Mark Hebeka, a banking equity analyst at S&P. "The larger banks are generally more diverse and less sensitive to the yield curve. Also, a rate hike should be factored in to most investors' expectations."

Jason Seo, the S&P equity analyst who follows small bank and thrift stocks, agrees that since the Fed acted as expected, there will probably be only a moderate reaction in the prices of stocks he follows. Similarly, real estate investment trusts were already priced to reflect a Fed hike, in the view of S&P analysts.

CYCLICAL PROGRESSION. "We think investment banks and asset-management firms can continue to grow earnings despite rising interest rates, as we think the industry has demonstrated over the past year," says Robert Hansen, an S&P equity analyst, citing Lehman Brother (LEH

; S&P investment ranking 4 STARS, buy; recent price, $114), Bear Stearns (BSC

; 5 STARS, strong buy; $104), and Goldman Sachs (GS

; 5 STARS; $119). "All three of these beat our per-share earnings estimates in the August quarter, despite rising interest rates, in part due to higher trading revenue, merchant banking gains, and higher M&A fees."

If the Fed's Sept. 20 statement is viewed as an outlook for moderate economic growth without a lot of inflationary pressure nor a likely need to raise interest rates much further, it should help discretionary cyclical stocks, says Tom Graves, an S&P equity analyst who heads the analytical group that follows consumer-discretionary issues.

The most rate-sensitive segment in S&P's discretionary cyclical coverage universe is probably the homebuilders, Graves notes. When investors evaluate prospects for that group, he says, there's likely to be a cross current between prospects for consumer spending and confidence and expectations for interest rates.

PRINTING CASH. S&P believes that expectations of moderate economic growth, combined with easing pressure on upward interest rates, should be supportive of homebuilder stocks such as Beazer Homes (BZH

; 5 STARS; $57), Centex (CTX

; 4 STARS; $66), D.R. Horton (DHI

; 4 STARS; $36), Hovnanian (HOV

; 4 STARS; $53), Lennar (LEN

; 5 STARS; $57), MDC Holdings (MDC

; 5 STARS; $76), and NVR (NVR

; 4 STARS; $852).

What about groups that are typically considered less rate-sensitive? Publishing companies are likely to follow the overall direction of the market, though with less volatility, in the opinion of S&P equity analyst James Peters. That's because he sees the industry as flush with cash. The majority of companies in his coverage universe aren't as leveraged to changes in interest rates as stocks in some other sectors may be. Though Peters sees the rise in rates as likely to hurt consumer demand in the short term, he also believes it may actually stimulate spending on advertising in some parts of the country.

Technology stocks could get a boost from the rate hike. "My sense is that the rate hike signals the Fed's confidence in the economy's strength, which would be a positive for tech stocks. Moreover, an increase would perhaps indicate that the Fed is closer to concluding its tightening, which would also be good for tech stocks," says Scott Kessler, group head for technology equity analysis at S&P.

HEALTH-CARE PROGNOSIS. However, the rate hike could present a small negative for the health-care sector. "Pharmaceutical stocks are being supported by high dividend yields, and more competitive yields on other investments would, in our view, draw away some investment capital from the subsector," says Robert Gold, group head for health-care equity analysis at S&P.

Gold also expressed concerns about other subindustry groups within the health-care sector. "We think valuations in biotech [issues] are always hurt by rising interest rates, similar to the other high beta [more volatile] areas of the market," he says. In most of the other segments within health care -- such as devices, facilities, HMOs, and services -- S&P generally doesn't see any direct connection between the Fed decisions and stock performance.

However, S&P thinks currency shifts do meaningfully affect the device group, which generally outperforms the market when the dollar weakens and underperforms when the dollar strengthens. "So if the Fed sees continued economic strength, boosts rates, and the dollar rallies, our expectation would be that device names would lag," Gold says.

Sectors and industries in which investors have already priced in the Sept. 20 increase, in S&P's opinion, include telecommunication services and equipment, utilities, and autos.

BEAR IN RETREAT. Overall, S&P expects the stock market to start moving higher. As a result of the Fed's latest move, "we expect the equity markets to begin to anticipate the eventual end to the rate tightening policy and close higher on the year," says Stovall.

S&P's Investment Policy Committee believes investors will continue to banish their bearish concerns. The committee maintains its yearend 2005 target price of 1,270 for the S&P 500, implying a 4.8% year-over-year increase and 3.1% advance from current levels. Also supporting this end-of-year advance is S&P analysts' expectation for a 16% year-over-year increase in operating earnings for the S&P 500 during the upcoming third-quarter reporting period and a 14% gain for the entire year.

Of course, there will be some obstacles to overcome for the market's advance. "Since the Fed started raising rates late in June, 2004, the U.S. equity markets have been able to climb a wall of worry consisting of rising interest rates, climbing energy prices, decelerating corporate earnings, and an aging bull market," says Stovall. And in S&P's view, the market's impressive resilience should continue.

Piskora is managing editor of S&P Global Editorial Operations

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