The U.S. Federal Reserve raised rates in March, which was the first interest rate hike since 2018. The so-called "dot plot" predicted a total of seven rate hikes in 2022 and has forecasted a federal funds rate between 1.75 percent and 2.0 percent by the end of the year.
What are secular growth stocks?
Secular growth stocks are companies that are witnessing long-term growth that's more or less independent of the business cycles. Electric vehicles, cloud, e-commerce, and cybersecurity are a few industries that are witnessing super high growth, which is expected to sustain over the next several years, if not decades.
Taking Tesla as an example, the Elon Musk run company expects its deliveries to rise at a CAGR of around 50 percent over the medium term. Cloud company Snowflake, which went public in 2020 and counts Warren Buffett’s Berkshire Hathaway as an investor, has forecast that its revenues will increase at a CAGR of almost 45 percent until 2028.
Cybersecurity is another good emerging secular growth story. Countries and corporations will need to spend more to defend themselves from cyberattacks. Similarly, e-commerce continues to account for a growing chunk of overall retail sales. Simply put, these are emerging industries where demand isn't a concern for the foreseeable future.
What are cyclical stocks?
Cyclical stocks are almost the mirror opposite of secular growth stocks. Metals, energy, semiconductors, banking, and legacy automakers are examples of cyclical companies. The demand for these companies rises rapidly in an economic upturn. However, the demand falls in an economic downturn.
Over the last 18 months, we’ve seen a breathtaking rally in cyclical stocks, especially in the metals and mining industry as commodity prices go through the roof. Several commodities including steel, aluminum, and copper have hit record highs during this period, which is also reflected in the stock prices of companies producing them.
Recently, energy prices have spiked amid the Russia-Ukraine war. While energy prices have come off their 2022 highs, they're still quite high compared to 2021. Even Buffett has been pouring billions of dollars into buying shares of Occidental Petroleum. In 2021, he also bought shares of energy giant Chevron.
What do the Fed’s rate hikes mean for secular growth stocks?
While the Fed’s rate hikes don’t impact the demand environment, they do take a toll on their valuation multiples. The terrible sell-off that we’ve seen in growth stocks, many of which are secular growth stories, exemplifies how higher interest rates are negative for secular growth companies.
Since these companies’ earnings are skewed towards the future, those cash flows become less valuable when discounted at higher rates. That’s why growth stocks, especially those of loss-making companies, have tumbled over the last six months.
How are cyclical stocks impacted by higher interest rates?
Higher interest rates invariably have a negative impact on economic activity. Higher interest rates could lead to lower demand for housing and vehicles, which in turn impacts the demand for metals. So, higher interest rates are also negative for cyclical stocks.
Jim Cramer likes these secular growth stocks.
Cramer listed Tesla, Deere, Devon Energy, and Apple as examples of secular growth stocks. Of these companies, Devon Energy is cyclical since it's an onshore oil and gas exploration company. Even Deere isn't a secular growth stock per se even though the company could see high growth over the next few years due to higher demand for farm equipment amid high farm produce prices.
What stocks should you buy now?
Looking at the economic environment, it won’t be prudent to jump into either the secular growth stocks or cyclical stocks without doing your due diligence. Looking at Cramer’s picks, Apple looks like a good secular growth stock that's available at reasonable valuations.
Alphabet looks like another secular growth stock to buy amid the digital transformation. Amazon is another good secular growth stock since most of the industries where it's present including cloud, e-commerce, digital advertising, and streaming are secular growth industries.
Some of the cyclical stocks also look good. Freeport-McMoRan, which is the largest U.S.-based copper producer, is a mix of secular growth and cyclical. The outlook for copper looks bullish amid the EV transformation.
Concerns about the copper supply will only get worse if Chile, which is the largest copper producer, works towards nationalizing the country’s mineral reserves.
Overall, it might be better to look out for companies that offer good secular growth but are available at reasonable valuations. Richly valued secular growth stocks might feel the pain as the bond yields rise due to the Fed’s rate hikes.