Rising interest rates in the U.S.? │ No worries!

Are you concerned about rising interest rates effect on stocks in the U.S.? Keith Richards, portfolio manager at Barrie, Ont.-based ValueTrend Wealth Management and a frequent contributor to The MoneyLetter, says you should find something else to worry about. Mr. Richards’ market outlook calls for liftoff and tells you how to profit from it.

I’ve been in the financial industry since 1990, first as an investment advisor with both small and large brokerage firms, and then later as a discretionary portfolio manager. Throughout those 25 years, I have lived through a few periods of rising and falling interest rates effect on U.S. and Canadian stock markets.

I’d like to see if we can draw any assumptions out of past stock market behavior and interest rate policy by the U.S. Federal Reserve over that time period.

The U.S. prime rate is the rate that is charged by the banks to their best commercial clients. Note that individual clients are often charged variables above or below prime depending on the loan type and credit rating.

Moving in tandem: Prime Rate, S&P 500

In any case, the U.S. prime rate and the S&P 500 Composite Index have tended to move in harmony during my career. They have been correlated in movement since 1990, with one exception, in the early 1990s when the prime rate fell, but markets rose.

The Fed fund rate, the rate that banks charge when lending to each other, is also correlated to the S&P 500’s movements. So, it would appear that rising rates don’t hurt the stock market—at first.

When trouble comes

Where the trouble comes in is when rates peak. That of course occurs after they have risen for a while, and the Fed policy to tighten is finally doing its job; that is, they are finally cooling things down. The stock market typically declines only after a period of rising rates.

What to expect from the fed

I’m no economist, so I’ll defer the in-depth side of this analysis to those who know a lot more than I on this subject. However, it would appear to me that the pending tightening by the Fed—whenever it may occur—is not going to be so harsh on the markets. At least for a while.

It also occurs to me that the Fed’s tightening strategy will likely be pretty incremental, given the Federal Reserve’s very obvious understanding of its influence on stock markets (and the consequential “wealth effects” of strong markets). Further, U.S. interest rates are coming off of an artificially low level to begin with, which may mute any negative effects further.

What to expect from rising interest rates

So for those who fear the eventual rise in interest rates on the U.S. side of the border when viewing their stock holdings, I’d probably find something else to worry about. If anything, rising interest rates will likely suggest an extension of the bull market for a couple of years, if not longer.

Moreover, there are opportunities that arise when we examine the implications of a rising interest rate environment in the U.S. For example, the market outlook for U.S. financial stocks in the insurance and banking industry is for increasing profitability on rising rates. Banks can increase their margins on loans, and insurance companies reap higher profits from their largely interest-rate driven investment portfolios.

How to get exposure to U.S. bank stocks

At ValueTrend, we own direct U.S. bank exposure through a broad-based bank exchange traded fund (ETF), run by the BMO Financial Group—namely the BMO Equal Wt. US Banks ETF (TSX─ZUB). For those who worry about the currently strong level of the U.S. dollar, this ETF is currency hedged. The ETF has some significant technical resistance on the horizon near current prices of $22 a share. However, seasonal influences and rising rates may allow this sector to blow through that resistance as we move into the spring. We also have exposure to an individual regional U.S. Bank through BB&T Corp. (NYSE─BBT). Its technical resistance lies around US$40 to $41 a share.

For broader exposure to U.S. financial stocks . . .

For investors who would like additional exposure to U.S. financial stocks via the insurance industry, consider First Trust AlphaDEX US Financial Sector Index ETF (TSX─FHF). This exchange traded fund employs a screening process to weight the financial index called the AlphaDEX™ methodology. The ETF has only been around for about a year, but its index-based returns will make it similar to buying a U.S.-listed financial index ETF—with no currency hedging.

How U.S. interest rate hikes may play out in Canada

I’d like to note that the rising rate scenario in the United States is not so encouraging for the Canadian market outlook. A rising rate environment south of the border will likely continue to put pressure on the Canadian loonie.

Further, some commodities can be quite sensitive to a strong U.S. dollar—especially the precious metals. There can also be some pressure on base metals and even energy if the U.S. dollar rises further.

No amount of pumping money into government coffers and infrastructure expenditures will solve an economic recession in Canada if global forces continue to punt the resource sector. As such, there would be little to suggest that the loonie will strengthen—and very little hope for Canadian interest rates to rise in the near-term. As a result, I expect to continue to avoid resource-based stocks for the time being.

Low rates hurt Canadian financial stocks

Further, the continuation of a low interest rate environment is not encouraging for the Canadian financial sector’s profits. While I do hold a position in a couple of Canadian bank stocks—specifically Bank of Montreal (TSX─BMO) and Canadian Imperial Bank of Commerce (TSX─CM)—I view these as relatively short-term trades from an oversold condition, rather than long-term holds.

The ‘stealth’ market

Through my writings for The MoneyLetter and other publications, as well as my television appearances, I’ve referred to the market over the past couple of years as a “stealth” market. That is, one that sees money rotate from winning stocks into depressed stocks, and vice-versa. Rotation from sector to sector is also becoming faster and more pronounced of late. Be aware of the effects that interest rates and currencies can have on your holdings, and prepare to rotate out of those stocks and sectors that are losing ground and into those that will benefit.


The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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