Stocks: Where to Ride Out the Rate Spike

The sudden rise in interest rates may weigh on financial and utility companies, but energy and food stocks should fare better

A variety of economic data, especially reports showing a solid job market, spread the view that inflation fears could prevent the Federal Reserve from cutting interest rates this year. Some think the Fed may even be forced to raise rates if the economy and inflation overheat (see, 6/7/07, "What's Behind the Interest-Rate Spike?").

And worries about rates and inflation caused a lot of grief on Wall Street in the first full week of June. Stocks tumbled as Treasury yields pushed past the magic mark of 5% (see, 6/8/07, "Stocks: An Upbeat End to an Ugly Week").

If rates are staying higher, how should investors react? Many pros think investors who are worried about higher interest rates and higher inflation might be wise to sell financial and industrial stocks, and buy up energy and food companies.

Much of inflation's impact is basic economics. "If people have to spend more money on food and gas, they spend less on TVs and furniture," says Bryant Evans, a portfolio manager with Cozad Asset Management.

Solid—and Shaky—Ground

What areas of the stock market could take a hit? Sam Stovall, chief investment strategist for Standard & Poor's, studied the effects of previous interest rate hikes on stocks. He says the financial sector, industrial stocks, consumer discretionary stocks, and utilities tend to fare the worst. Doing best when rates rise are energy, health, and consumer staples sectors, Stovall says. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies.)

( readers can get more detailed information on stock market sectors by opening the Sectors & Industries tab at the top of the Company Insight Center.)

S&P now predicts the Fed won't cut rates until early 2008.

Evans says he's paring back exposure in his stock portfolio to the sectors especially sensitive to inflation and rising rates. He likes consumer staples stocks, along with agriculture. Also, he says, utilities are usually hurt by rising rates initially, but in the long run they do well in a weaker economy.

Interest Rate Rundown

Stovall is wondering what effect higher rates might have on the "breakneck pace" of mergers and acquisitions. Takeovers, private equity buyouts, and stock buybacks, which all rely on relatively low interest rates, have been pushing markets higher.

Many are also watching the housing market closely. With the sector already reeling from a glut of supply and falling prices, could higher rates slow home buying further? "The one thing the housing market had going for it was low rates," Evans says.

Of course, Evans notes, even if rates rise, they're still low on a historic basis. Indeed, the news on rates points to problems, but it's no time to panic. "I don't think we want to paint some kind of gloom and doom situation," Evans says. "The economy has a way of working these things out."

Nor are higher rates a certainty. Todd Salamone of Schaeffer's Research sees technical reasons that the rise in bond yields may be at an end. Also, an inverted yield curve for bonds—when short-term yields are higher than long-term yields—which is usually a sign of economic trouble, seems to have ended. Short-term rates didn't rise as much as long-term rates, Salamone says, "which could be a positive for stocks."

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