Here's your playbook for rising interest rates

The Fed may start tapering in just a few months. Here are a few of the likely winners and losers.

By StreetAuthority Dec 6, 2013 6:16PM
Image: Crystal ball (© Randy Allbritton/Getty Images)By David Sterman                                                              

Let the jockeying begin. Strategists are predicting a major change in interest rates in 2014 and 2015, and have already begun to identify the fallout -- positive and negative -- on a wide range of stocks. As long as you follow the game plan, your portfolio is likely to benefit.

There are two extremely likely scenarios for 2014. First, the Federal Reserve is expected to keep the federal funds rate near zero, which will keep interest rates on shorter-term lending rates very low.

Second, the Fed will ease off its massive stimulus program (known as quantitative easing, or QE), which is likely to allow long-term rates to rise to levels that truly reflect global economic activity. (The QE program has kept a lid on long-term rates.) I discussed this notion a few weeks ago in my look at the soon-to-change yield curve.

Historical trends suggest that certain sectors are likely to benefit while other sectors are likely to lose some appeal with investors. And even within sectors, clear winners and losers will emerge.

Not all yield plays are the same
First, let's get the obvious impacts out of the way. Any income-producing investments such as utilities, real estate investment trusts (REITs) and master limited partnerships (MLPs) are bound to suffer. The SPDR Select Utilities Fund (XLU), for example, has lagged behind the broader market since May, when investors first sensed that the QE program would soon come to an end. Look for this trend to continue in 2014.

In a similar vein, the JPMorgan Alerian MLP Index ETN (AMJ), which tracks many of the country's high-yielding pipeline MLPs, has lagged the S&P 500 Index by more than 15 percentage points since May.

That doesn't mean that all yield plays will be shunned. As we've noted recently, companies with rising payouts will still hold appeal. Analysts at Merrill Lynch concur: "We prefer dividend growth stocks over simply high dividend yields as a good hedge against rising rates," they wrote in a June report.

In fact, the steepening yield curve will be great news for any companies holding significant cash balances. Higher rates should enable these firms to generate higher interest income, which I discussed in October. If you're looking for sectors with lots of cash, then the tech sector should be your focus. And tech stocks have a historically positive bias when rates are on the rise, regardless of cash balances. Merrill Lynch suggests that the 2014 rate scenario will be very similar to the scenario seen in 1994. Back then, rates rose higher in tandem with a slowly strengthening economy, and tech stocks rose 19%, the best gain for any sector. (Utility stocks fell 17% that year.)

Rising rates have historically been kind to energy stocks as well. That's because higher rates are often accompanied by higher rates of inflation, which are often correlated with rising energy prices. However, this link may not play out in 2014, as inflation is calmer than a bear in winter.

Know your financials
While the playbook for many sectors is cut and dried, the strategy around bank stocks is more complex. Many banks have a much greater focus on short-term interest rates, while other banks are better positioned for moves in longer-term rates.

Right now, a number of banks such as Citigroup (C) derive most of their net interest income (that is, the spread between their borrowing and lending costs) from the spread in short-term rates. In contrast, many regional banks are structured to generate most of their net interest income from long-term bonds. Goldman Sachs cites Regions Financial (RF) as a clear beneficiary, as more than 60% of net interest income is derived from the spread between long and short rates.

Among the large banks, JPMorgan Chase (JPM), with more than 40% exposure to long-term net interest income, is a Goldman favorite, adding that the bank "has the most inexpensive valuation in the group on 2014 and 2015 EPS."

To be sure, the housing market stands as either a positive or negative for banks stocks as well. If rising rates (and higher mortgage interest rates) start to weigh on home sales, then profits from mortgage underwriting are bound to slump. Wells Fargo (WFC) and Fifth Third Bancorp (FITB) derive an outsize portion of their business from mortgage activities and appear most vulnerable to higher mortgage rates.

Then again, these banks have greater upside if the housing market delivers a better-than-expected performance in 2014. My take: The recent housing weakness is likely to persist for at least a few more quarters, but the outlook into 2015 and 2016 is far brighter.

Risks to consider: If longer-term rates don't rise in 2014 in tandem with a pullback in the QE stimulus program, then investors will grow concerned that the U.S. economy remains distressingly weak. That's a negative scenario for the potential beneficiaries noted above and likely a positive for more defensive stocks such as utilities and MLPs.

Action to take: It's quite likely that the Fed will start tapering the QE program in the next three to four months -- if not sooner -- and you need to adjust your portfolio in advance. Stress-testing each portfolio holding in terms of interest rate sensitivity is an exercise you should begin soon, if you haven't already.

More from StreetAuthority
Dec 8, 2013 11:45AM
What about us poor shmucks who spent a lifetime carefully saving our money so we could have it work a bit for us in our retirement?  Oh, right!  We have to think first of those poor bankers and big-time investors.  Have a nice day.
Dec 6, 2013 8:32PM
Here's the main thing you need to know about rising rates:

There are triggers in place for a huge stock sell-off the moment the yield on the 10yr tops 3%. 

Dec 8, 2013 1:38AM
The Privately owned Bank The Federal Reserve, is about to find out what happens to FIAT CURRENCY. All of us will suffer because of the GREED of the VERY FEW.  The real Question should be "What are YOUR PLANS for the GLOBAL MELT DOWN" 
Dec 7, 2013 11:43PM






Dec 8, 2013 9:15AM

The term "interest rate" is irrelevant in the scenario where they increase. Higher interest rates mean more income is required to quality, more out-go is required to pay for life and living. In spite of all the blog comments regarding the TRUE state and nature of the economy, Inflationists have plodded on. It's in the book, boys and girls... Fiat Money Inflation in France by Andrew Dickson White. There is a goofy perception that we have an economy. We don't. We have a nothing.

Some insight on where we are: BIG can't find the skill sets it needs and argues about Minimum Wage labor. The 800 pound gorilla in the room is inept management that can't train, and a growing disdain with not making ends meet for the majority. It's a "business arrangement" really, not a platform, if it exists in total dysfunction. Expect rising rates to sink top-heavy vessels that cannot do enterprise.

It may seem weird but... better homes will rise in value and sell with higher rates. Entry level and estates-- not so much. In fact, estates will stagnate because of credit tightening. There is at least a 4:5 ratio of bad credit lower-income borrowers to stable solvent ones. That means fewer quality in tighter disciplines. Rental rates are already too high. Use your noodle... if you can't earn a good enough living and can't afford to rent-- you quit.

Without QE, every single stock begins the steady ramping into decline. There are no consumers to bamboozle, the I-Phone crowd is broke, 4th quarter retail sales will be dismal, borderlines will file for bankruptcy protection before entering inventory count season and mass-marketed commercial sports merchandising is already sliding. The era of exploitation is shutting down. The era without momentum delusion begins.

Based on days like last Friday, odds are that we now exceed $700 TRILLION in derivative debt. It gets used to fuel rallies. When rallies fail to generate any substance, they turn into debt and those stock shares thin in tangible value. What did you ever actually have? Game tokens, at best.

It isn't rocket science... if a stock or commodity certificate once meant you owned something in the former tangible world, it can only be that possessing them means you OWE something in a world that views derivatives and debt obligations as currencies and GDP. The old rules are long gone. Derivatives prioritize ABOVE stocks in liquidation. READ your fine print.  

Dec 8, 2013 8:57AM
ActiveRIA gets it!
A good read for an individual who has had PONDX / PIMIX as a mainstay for years. 

I am of a mind that a lot of great income plays will be going on sale over the period when the Fed is forced to pull the plug (diminishing returns / unintended consequences).

What bag will you be left holding?

Dec 9, 2013 2:16PM

V_L......Most of us have read that already, somewhere else...

The ones that haven't don't really care about the FED nor the Markets; They are not invested.

Or do not understand the implications of FED easing anyway...imo.

Dec 8, 2013 4:30PM
Obamacare will kill world wide market invest vestment because of monthly premiums will be 7x's more than currently paid. Monkey face bastard waving his hands around and looking down at the floor when he lies and talking poop! Also laughing at us, thumbing his nose at us,  and insulting our intelligence...Thank-you. I feel a little better.
Dec 8, 2013 9:28AM

 "bank-loan" fund SAMBX should prove to be a very palatable combination within a further diversified income portfolio."

How so? Every holding it has is market-volatile in an interest rate ramp up. Tranches are collectives of existing credit. What aspect of a sell-off indicates continuation to settlement? The fact is-- although a majority of platforms are cash-rich, they have substantial debt. A singular move like tapering damages the income and outgo flow. You are saying that an Albatross with it's wings clipped is still capable of running. In fact, it would be extra uncoordinated.

Dec 7, 2013 10:20PM
 Come on until the great Obozo is gone the markets will remain dependent on welfare and fraud.
Dec 9, 2013 12:44PM

NEW YORK- The vast majority of business economists believe the Federal Reserve will begin to pull back on its massive economic stimulus program in the first three months of 2014, according to a November survey done by the National Association of Business Economists.

The survey also showed a majority of economists believe the United States' economic recovery will accelerate next year. NABE surveyed 51 economists between Nov. 8 and Nov. 19 and found that 62 percent of respondents believe the Fed will pull back on its bond-buying program in the first quarter of 2014. Another 30 percent believe the Fed will begin to reduce its bond buying in the second quarter of 2014. Combined, nine out of 10 economists believe the Fed's stimulus program will wind down next year, after being place in its current form since December 2012."

10 out of 10 is these so-called "experts" get paid salaries born out of QE and most have never worked an enterprising day in their life. From burger maker to college student to number person without stopping to engage is the REAL economy-- at all. 

Let's review the facts they missed... no American business platform contains competent skilled people who can run enterprises without QE. They can't find anyone who can. They suppressed the nation to Minimum Wage and under-skilled roles for 5+ years now. They wiped out housing values, then made trillions of dollars worth of too-low-to-service mortgages to people who still think they can walk away and move up-town. The Tech Giants lobby for privacy but never stopped their venues from making job blockades and stonewalls blocking the competent from careers that kept them from destitution.

Validate ANY amount of Kool Aid you choose to, but America DIES next year. QE ruined us and all those contaminated by it through investments need to pay for Holocaust-level crimes against the people of America. We are $700+ TRILLION in debt to derivatives. We have no cooperation among elected Officials and some pledged to ignore the states that elected them for a "party" agenda. That's CRIME. Where is the PUNISHMENT? 

Dec 8, 2013 9:04PM

What about utility stocks?  I say sell before rates increase.


Dec 8, 2013 9:00PM

Crazy`8:I guess there`s no hope for extreme right wing haters like yourself.The best thing that

those who hate the country,hate Obama,hate the Constitution, is for them to leave the country.

It`s like in school when the cl**** gets kicked out,the class improves.

Dec 8, 2013 7:55PM
Crazy 8`s;When you lose an argument just call the Dems commies.
Dec 8, 2013 1:47PM
It's amazing how the market concentrates its focus on a particular thing. That thing is will the Fed taper or not? Eventually the Fed will ease back it current policy, but it won't happen until the Fed gets enough data to be sure that the economy no longer needs its help. That shift in policy will take more than a couple of months of "good" data. The problem is that there is a great lag between applying policy and getting results. This recession has been devastating to the point the Fed can't make any mistakes. Also adding reserves to the banking system to buy MBS and Treasury bonds has no really bad effects on an economy that is generally very weak. Besides keeping rates down, it is no more than changing some numbers on the bank accounts at the Fed. 

The Fed has total control over the Fed Funds rates, the shortest rate, but  global economic demand will determined the shape of the yield curve. Currently the Fed can influence it, but its ability to do so will recede as our economy and the world's improves. 

Recent data over the past few months reflects that  is beginning to happen. Auto, housing, jobs, GDP, corporate profit, and even Europe are all on the mend heading up. Will it continue or will the economy falter sinking back into stagnation? If you don't believe in free market capitalism which is what powers the economic engine of America, you shouldn't be in the market. Buy some Gold, or some bonds. If you do believe, stocks are the only place to be, because the former two won't do much for you.

As this article tries to point out, in a stronger economy, rates are bound to rise; however, considering where they are, historically very low, and just how weak the economy is they'll have a long way to go up before they pose any problems. Also the market can continue to go up for a long time even with high rates. 

I see this Bull as the Mother of all Bull Markets, so I predict the market will easily see $17K+ in 2014. In fact, the party hasn't even started. If you examine the general enthusiasm for stock, it is very tepid. The public is pretty much negative on stocks, Wall Street, and probably life in general. Why they aren't too happy with their hero Obama which I believe will drive the market higher.

Yes this time next year I'll be going har har har clutching big fists of cash! What will you be doing? Going to the food banks, whining about the cut backs in welfare, and dining at the Salvation Army?

Yuk yuk!

Dec 8, 2013 6:21PM

ACA isn`t perfect but OMG is it needed.I have relatives in sales that couldn`t get insurance

because of pre-existing conditions.They`re thrilled to get ACA.Nobody said it would be free.

Well, maybe the idiots on Fox who wouldn`t know the truth if it hit them in the face.If the right

loved this country as much as the Dems they would work with Obama and try to improve it instead

of spreading their lies.

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