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
From Standard & Poor's Equity ResearchThe 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.
S&P 500 Sector Performances After Rate Hikes Since 1970 (% change)
NA-Not available. Source: Standard & Poor's
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.
The Telecommunications Services sector shows NAs, since it was created in the mid-1980s with the breakup of the Bell operating system and therefore does not have an appropriate amount of historical observations. Technically, the same could be said for the Information Technology sector, as it consisted of only two to three industries in the 1970s and 1980s, as compared with the 15 we have today.
Where to Invest
S&P's Investment Policy Committee is maintaining its yearend 2007 target of 1510 for the S&P 500 because of the risk of higher interest rates and the potential for slowing earnings growth. We advise overweighting the S&P 500 Consumer Staples sector due to the counter-cyclical nature of demand for many of the sector's products, coupled with increasing international sales exposure, which we believe will likely cushion vulnerability to slowing U.S. economic growth.
In addition, we recommend overweighting the Health Care sector as we believe investors will gravitate toward sectors with high earnings-per-share (EPS) growth visibility and historically defensive characteristics in an environment of slowing EPS gains for the overall market stemming from an aging economic expansion.
During the week of June 4, S&P's Equity Strategy Group reduced the recommended exposure to two sectors: financials (now marketweight) and utilities (now underweight), due to the increased risk to an upward bias in interest rates. We recommend overweighting the S&P 500 Consumer Staples sector—which is tracked by an exchange-traded fund (XLP)—and the Health Care (XLV) sector and underweighting the Consumer Discretionary (XLY), Materials (XLB), and Utilities (XLU) sectors.
Industry Momentum List Update
Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of 5 (price performances in the past 12 months that were among the top 10% of the 136 sub-industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).
S&P STARS Rank
R.R. Donnelly (RRD)
Lyondell Chemicals (LYO)
Apple Inc. (AAPL)
Construction & Engineering
Jacobs Engineering (JEC)
Vulcan Materials (VMC)
Diversified Metals & Mining
Freeport-McMoRan Copper (FCX)
Fertilizers & Agr. Chem.
Integrated Oil & Gas
Exxon Mobil (XOM)
Integrated Telecom. Svcs.
Citizens Communications (CZN)
Metal & Glass Containers
Ball Corp. (BLL)
U.S. Steel (X)
Arrow Electronics (ARW)
Tires & Rubber
Goodyear Tire (GT)