Sectors: Will Rising Rates Wreak Havoc?

S&P looks at recent history and finds that higher yields tend to ding financials and industrials, while health care and IT hold up better

by Sam Stovall From Standard & Poor's Equity Research

The yield on the 10-year Treasury note has risen from 4.63% at the end of April to 5.25% recently, only to back off slightly to 5.14%. We think rates will head higher in the coming months.

David Wyss, S&P's chief economist, projects the yield on the 10-year note to close 2007 at 5.22%, rise to 5.55% by the third quarter of 2008, and remain at that level during the remainder of the year. But he believes the rise in U.S. rates has more to do with the repatriation of foreign investments in search of higher yields closer to home than he does a pickup in the rate of U.S. inflation.

Fed Unlikely to Cut Rates Before 2008

Wyss forecasts the core consumer price index to advance by less than 2.25% in each of the coming three years. He thinks core inflation is under control and reminds us that a key inflation gauge, the personal consumption expenditures deflator, is up only 2% from last April, and now sits atop the Federal Reserve Board's "inflation comfort zone." He expects the Fed to delay cutting rates until early 2008, since the unemployment rate remains low, and he thinks any early move would be a hike, caused by an upside inflation surprise.

Mark Arbeter, S&P's chief technical strategist, also believes that yields—after backing off from the 5.25% level in the near term—will subsequently rise to the 5.4%-to-5.5% range before this intermediate-term move is over.

If these forecasts come true, what may higher rates do to sectors within the S&P 500? While we are not approaching the beginning of a rate-tightening cycle, I believe the impact of higher rates on sector performances will be similar to that following the first rate increase, knowing full well that past performance is no guarantee of future results. The table below shows how S&P 500-Stock index industries (rolled up to the sector level, since S&P 500 Global Industry Classification Standard sector-level indices have no history beyond 1990) performed six and 12 months after the Fed started raising interest rates since 1970.

We clearly see that higher rates are not appreciated by investors, as eight of the 10 sectors posted average declines from 1% to 13% shortly after rates began to rise; seven of the 10 were still in negative territory 12 months later. In general, the highly cyclical, interest-sensitive sectors—like Financials, Industrials, Consumer Discretionary, and Utilities—were hit the hardest, while Consumer Staples, Energy, Health Care, and Materials suffered the least.