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History Doesn’t Repeat Itself, but It Does Rhyme

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Nov. 12 2015, Published 3:21 p.m. ET

Which sectors outperform and which underperform in a rate hike environment?

When, and if, the FOMC finally starts to hike short-term rates, there will be no shortage of pundits and analysts giving investment advice on where and when to invest. Instead of guessing, we decided to analyze the actual data. The problem is there just isn’t much data out there to look at. The FOMC has only hiked rates over multiple quarters three times in the last 25 years (there was one hike of 25 basis points in early 1997). Interestingly, in all three instances, the market rose.

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However, you had to be in the right sectors. Each of these eras was of course driven by different forces such as the peak of the tech bubble in 1999 and the voracious appetite of emerging markets fueling the commodity super-cycle, coupled with the real estate bubble of the mid-2000’s. The one we are in is in part a creation of global quantitative easing and effective currency devaluations. In these latter two cases, the equity market did not have much fuel left after the initial rise, and they were followed by two of the most epic market collapses in history: the end of the tech bubble and the Great Recession.

Why does the FOMC hike rates and are there sector-specific implications?

“The Congress established the statutory objectives for monetary policy–maximum employment, stable prices, and moderate long-term interest rates–in the Federal Reserve Act.”

This quote comes directly from the Board of Governors of the Federal Reserve System’s website. So in layman’s terms, the Fed curbs inflation by ensuring there aren’t too many dollars chasing too few goods, and vice versa. It wants to keep the unemployment rate low (but not too low) and attempts to keep interest rates from wildly fluctuating. However, the FOMC has recently stated its concerns about global growth as well – so add that to the list of unofficial factors influencing monetary policy.

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The sector winners in all three timeframes (some may surprise you)

Remember some sectors will discount rate changes well in advance and that choosing even slightly different timeframes will yield different results. The ten S&P 500 GICS Level 1 codes were used for this analysis. Also, keep in mind that every sector is operating within its own cycle. So for example, the information technology sector massively outperformed during the 1999-2000 hike as the Internet bubble made its final gasp higher (+62% versus +12% for the SPX). Although commodities tend to do well during rising rate environments, especially when accompanied by rising inflation, the 70% rise in energy should be discounted, as it was emerging market demand that fueled much of that performance.

Notice the disparity in returns over the years for some sectors. The technology sector in 1993 (no Internet) is vastly different from that of today. Now let’s look at a sector-by-sector breakdown of the winners and losers in a Fed hike.

Energy: Positive

Energy generally does well in all three timeframes. Given the most recent downdraft in energy that has hurt companies like Royal Dutch Shell (RDS.A), ExxonMobil (XOM), and Chevron (CVX), coming into a possible rate hike in addition to the fact that energy historically performs well during a hike, the setup for a rebound looks to be in place. The 70% return in 2004-2006 is abnormally high because of the Asian-fueled commodities boom, but there is outperformance consistently nonetheless. In this particular environment with a strong US dollar, BlackRock’s iShares Commodities Select Strategy ETF (COMT) is best positioned to reap the benefits of both the energy sector as well the materials sector rising, as commodities may find a bottom as inflation expectations kick up.

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Industrials: Positive

All three timeframes saw better performance from industrials. This group could be a keeper in a rate-hike environment. BlackRock’s iShares US Industrials ETF (IYJ) can help you gain exposure to the sector.

Materials: Mixed

The data is mixed with two outperforming periods and one underperforming period. But the chance for a rebound might be present here as well with most materials stocks at multi-year lows. The iShares US Basic Materials ETF (IYM) is down 11% for the year and provides exposure to heavyweights from this sector.

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Utilities: Mixed

The data here is decidedly mixed. The returns from 2004-2006 were most surprising, given that conventional wisdom is to get out of utilities during a hike since their dividend yields will no longer be as attractive. However, rates are so low that utility yields may still be attractive at 3%-4% versus the Fed fund rate at a post-hike 1%. The iShares US Utilities ETF (IDU) has a distribution yield of 3.3% as of the end of October 2015.

Telecomm: Mixed

This too seems like a sector people would avoid, as telecom yields become less attractive as rates rise. But here, again, returns were strong in the 2004-2006 period. As with utilities, investors may conclude that 5% yields are still preferable to 1%-2%. As of October 2015, the distribution yield of the iShares US Telecommunications ETF (IYZ) was 2.0%.

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Technology: Mixed

This sector obviously had spectacular returns in the 1990’s but saw a less-than-stellar 2004-2006. This sector tends to be more speculative and expensive, so outside of a giant secular growth market like in the 1990’s, it may fare poorly. Investors in the iShares US Technology ETF (IYW) need to be wary.

Financials: Mixed to worse

This too is a bit surprising. In all three periods of rising rates, returns in financials were in-line to worse. Most analysts would say that financials benefit from a rate hike environment, and that is likely true in the initial stages of a hike. But later on, high rates may choke off the personal and commercial loans that banks need to grow earnings. Thus, investors need to think hard about investments in ETFs like the iShares US Financial Services ETF (IYG) and the iShares US Financials ETF (IYF).

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Healthcare: Mixed to worse

These stocks did poorly except in 1993-1995. This may surprise investors since conventional wisdom would say people still need healthcare regardless of the interest rate environment. However, these stocks also tend to be fairly expensive, especially on the speculative biotech side, and a rate change would likely knock down those higher multiples. Due to this, investors should reconsider their investments in ETFs like the iShares US Healthcare ETF (IYH) and the iShares US Healthcare Providers ETF (IHF).

Consumer staples: Mixed to worse

This may be surprising to investors as well since people always need staples. However, these are still consumer stocks, and ultimately the FOMC wants to slow down spending.

Consumer Discretionary: worse

These stocks underperformed in all three timeframes. As the FOMC tries to slow down inflation, it usually ends up slowing down spending by consumers.

The mixed-to-negative performance of these sectors in a rising interest rate environment does not bode well for ETFs like the iShares US Consumer Goods ETF (IYK) and the iShares US Consumer Services ETF (IYC).

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