Wh at i f I n t e r e s t R at e s R i s e ?

A Special Commentary Series

the impact of rising rates on equities
In prior installments of the What If Interest Rates Rise? series, we discussed factors that cause
interest rates to rise and the influence that has on various asset classes. In this piece, we focus on
the effect of rising rates on equities, but in particular, the impact on various sectors of the stock
market since all do not usually move in unison.
Improvement in the private sector of the economy,
particularly the housing and labor markets, will
ultimately allow the Federal Reserve to move away
from its ultra-easy monetary policy. This, in turn,
will lead to shifting interest rates from todays low
levels. The normalization of interest rates will impact
sectors of the stock market in different ways. We
saw a preview of this in recent market performance
when the Fed first started discussing tapering its
asset purchase program. After the initial reaction
where the equity response was near uniform, those
sectors more cyclically disposed began to advance,
while the more classic defensive sectors lagged.
A longer-term reviewif past is prologuewhich
takes into account the last seven Fed tightening
cycles (policy shifts from loose monetary conditions)
going back to the early 1970s, provides a similar
pattern of sector performance. While every business
cycle has unique attributes, there have been a
number of consistent trends through time.
A Description of Stock Market Sectors
The broader S&P 500 Index is comprised of
10 economic sectors. Defensive sectors include
Consumer Staples, Health Care, Utilities, and
Telecom Services. These sectors are considered
defensive because changes in the economy and
interest rates have a muted impact on the revenue
and earnings of the companies within these sectors.
They produce goods and services that people need
or use regularly almost regardless of economic

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conditions. Many investors tend to rely on these

stocks for a dividend stream to provide income,
which has been the case in recent history when
bonds and cash offered such low yields.
Deep cyclical sectors include Energy, Information
Technology, Industrials, and Materials. These
sectors are considered deep cyclicals because
the economic cycle has a major impact on the
revenue and earnings of the companies within
them. When economic times are good, the stocks
within these sectors benefit from strong sales and
earnings performance as consumers and businesses
buy gadgets and machines, and make major
investments. When times are tough, these stocks
usually suffer disproportionately as these buyers
tend to cut back.
Interest-rate-sensitive sectors include Consumer
Discretionary and Financials. Low interest rates
make it easier for consumers to make purchases
from Consumer Discretionary companies,
especially on big ticket, durable items like housing
and autos. A financial stocks profitability is very
dependent on the interest rate environment.
Consequently, the performance of many stocks in
these sectors is sensitive to changes in interest rates.
Historical Sector Performance Prior
to Fed Policy Changes
Chart 1 summarizes historical sector performance
(relative to the S&P 500) six months prior to the
first Fed rate hike, and includes the last seven Fed

tightening cycles. Stocks react to economic news

by anticipating potential changes in the economy,
including the consequences of potential Fed
actions.
Chart 1 illustrates the performance of all
ten industry sectors over the last seven
tightening cycles. Notice the defensive sector
underperformance while the deep cyclical sectors
have outperformed. Financials only show modest
underperformance. Since the economy is generally
doing well at the time interest rates are set to, or
are rising, the deep cyclicals tend to perform well
because of increasing demand for their products.
On the other hand, defensive stocks may realize
solid earnings growth but it is usually not strong
enough to outperform the boost deep cyclicals get.
Chart 1: Sector Relative Performance and
Seven Fed Tightening Cycles
Percent Change
10

4
Energy

Consumer
Materials Industrials Technology Discretion- Healthcare Consumer
Staples Financials
ary

Utilities

Telecom
Services

(Source: Janney ISG, BCA Research)

Notes: 1) Average return of 7 Fed tightening cycles; 2) Performance is 6 months prior to first Fed rate
hike and is sector-relative to S&P 500 Index

Influence Of Current Economic Environment

The current economic environment provides several
unique characteristics that will impact performance
during the next Fed tightening cycle. The first major
difference is the extremely low current interest rate
environment. Todays interest rates are significantly
below the levels of the seven historical cases used
for Chart 1. This has forced investors to find yield
alternatives outside of the bond market. These yield
alternatives (bond surrogates) include defensive
sectors as mentioned, but also Real Estate Investment
Trusts (REITs), and Master Limited Partnerships

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(MLPs). It has also significantly impaired the

profitability of the Financial sector (more on this
below). A second major difference is that the
valuation of deep cyclicals compared to defensives is
below the depths it reached in the Great Recession of
2008/2009 with cyclical stocks relative to defensives
trading well below the average of the last fifteen
years. A closing of this valuation gap and cyclical
outperformance could occur even without improved
economic growth and interest rate normalization.
Given this current set of starting conditions and the
historical data, we would anticipate several things
happening as interest rates normalize. Defensive
sectors and bond surrogates should once again
under-perform, especially given the strong demand
these assets saw in this historically low interest rate
environment. As long-term bond yields rise, these
sectors should underperform as bonds become a
more attractive alternative again. While we remain
positive on the long-term prospects of REITs and
MLPs, especially as the economy improves, they
could be subject to a period of underperformance.
We expect the financial sector to prove a positive
exception this cycle. Banks and other Financials
have been hurt by todays extremely low interest
rate environment because their profitability is tied
to the difference between long-term and shortterm rates (they borrow short and lend long). This
sector should benefit greatly as the spread between
long-term and short-term rates widen (yield curve
steepens) with normalizing interest rates. Also, this
sector has also traded at a deep discount ever since
the financial crisis, and valuation should normalize
as investors are no longer concerned about
banking system assets and financial system risk.
A Note On The Impact of Inflation on Equities
The historical data also shows that inflation does not
significantly impact equity valuations unless inflation
rises above 4% as shown in Chart 2. Historically, the
inflation sweet spot for stock market valuation is
2-3%. When inflation is too low (<1%) the market
begins to fret about deflation. When inflation is too
high (>4%), the market worries about growth and
the erosion of purchasing power.

Given the current low level of inflation and the

Feds success at maintaining stable inflationary
expectations, we do not anticipate it will
negatively affect stock market valuation for the
foreseeable future.
Chart 2: Average P/E Ratios from 1871, at various Inflation Rates
Percent Change
25

20

15

10

0
Negative

0% 1%

1% 2%

2% 3%

3% 4%

4% 5%

5% 6%

Conclusion
In conclusion, a change in Fed policy that causes
interest rates to normalize will significantly impact
the equity markets. A rotation into cyclicals and
financials should be expected and would be
conducive to these sectors outperforming the
classic defensive sectors. While we recognize
the importance of maintaining purchasing
power through growing dividends offered by
many defensive sector stocks, we recommend
that investors maintain a significant exposure
to Financials, Technology, and Energy. This
agrees with our philosophy of maintaining a welldiversified portfolio that offers exposure to many
sectors and asset classes. Your Janney Financial
Advisor can analyze your portfolio and provide
recommendations to help manage risk and reach
your financial objectives.

Over 6%

Average CPI inflation, over preceding three years

(Source: Research Affiliates, using data from S&P and Yale economist Robert Shiller. P/Es are based on
S&P 500 and inflation data from U.S. Bureau of Labor Statistics.)

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This report is for informational purposes only and in no event should it

be construed as a solicitation or offer to purchase or sell a security. The
information presented herein is taken from sources believed to be reliable, but
not guaranteed by Janney as to accuracy or completeness. Any issue named or
rates mentioned are used for illustrative purposes only, and may not represent
the specific features or securities available at a given time. For investment advice
specific to your individual situation, or for additional information on this or
other topics, please contact your Janney Financial Advisor and/or your tax or
legal advisor.