What To Buy When Interest Rates Rise

Nick Lanyi's picture

Friday, May 27, 2016 - 12:30pm

by Nick Lanyi

It became clear late last year that the Federal Reserve intended to finally raise short-term interest rates, which it had kept near zero for years to allow the economy to recover from the financial crisis. Years into recovery, with unemployment low and some signs of inflation pressure, the Fed felt that rates could move slightly higher, while remaining historically low.

The first hike came in December, and most analysts expected two to three additional increases in 2016. But so far, no hikes have been announced this year. Weak economies abroad, continued rock-bottom energy prices and iffy corporate earnings all suggested that inflationary pressure was not a concern. 

But many Fed watchers now predict a mid-year increase when the Fed's policy committee meets in June, and Fed leaders have started telegraphing the possibility of a 25-basis-point hike (0.25 percentage points) at that meeting. With the economy continuing to grow, unemployment remaining low and other economic indicators positive, it seems likely that rates will go up, as the Fed seeks to balance the need to tamp down on inflation with the need to help the economy continue to expand. And the Fed historically has been reluctant to raise rates in the months before a presidential election, leaving June the last opportunity to do so until the end of the year.

A 25-basis-point increase in short-term rates will likely have minimal impact on the economy, but it will nudge other interest rates higher, including mortgage rates and mid-term bond yields. That will have consequences for several types of stocks. For one, banking stocks could be helped because such companies tend to be able to generate higher profit margins when interest rates rise. High-quality banking stocks are worth watching, though I'd continue to proceed with caution as the banking sector remains vulnerable to the weak energy sector.

High-yielding stocks, such as utilities, usually are hurt by higher rates because rising bond yields make stock dividend yields less enticing. However, as I wrote last fall, any selloff in utility stocks as a result of higher short-term rates is a buying opportunity. That's because rates are so low that it's unlikely that high-yielding utility stocks will face stiff competition from fixed-income investments in the near future. Note that even if short-term rates rise 50 basis points (0.5 percentage points) by the end of the year, 10-year Treasury bonds would yield less than 3%.

With all this in mind, here are two stocks to watch if the Fed follows through on its expected rate hike in June.

American Electric Power (NYSE: AEP) is one the nation's largest electric utilities, with the largest U.S. transmission network and 5.4 million customers in 11 states: Texas, Oklahoma, Ohio, West Virginia, Virginia, Tennessee, Indiana, Michigan, Kentucky, Arkansas, Louisiana. The company owns 32,000 megawatts of generating capacity, about half of which comes from coal, a quarter from natural gas, 6% from nuclear and about 11% from renewables and other sources.

AEP has diligently reduced its dependence on carbon-heavy coal, which accounted for 88% of its power generation in 1999; the company says its carbon emissions have dropped 39% since 2000. That's beneficial not only for the environment but for investors, as utilities heavily dependent on coal will face stricter regulations from federal and state governments in the coming years.

AEP's earnings rose at a 7.5% annualized rate from 2012 through 2016 (estimated), and the company aims for 4% to 6% growth going forward. AEP is financially strong and has increased its dividend at a 4.1% annualized rate since 2000. At recent prices, the stock yields a solid 3.5%.

Wells Fargo (NYSE: WFC), one of the largest banks in the nation, ranks #3 in total deposits and #1 in market capitalization. The San Francisco-based financial powerhouse operates in all 50 states and engages in retail banking, consumer lending, brokerage and retirement units but doesn't rely on investment banking. It's the top lender for commercial real estate, home mortgage originations and small business loans and #2 in auto loans.

Wells Fargo is growing revenue 4% to 6% a year over the next several years -- faster than its peers -- thanks to its national network, which facilitates cross-marketing of products, and solid customer relationships. Investors have been somewhat wary of the stock because of its exposure to energy-industry loans, but most analysts think that the risk is minimal and that the company's experienced management team has taken appropriate steps to write down assets as needed. 

Wells yields 3.0% at recent levels and is reasonably priced. If your exposure to bank stocks is in the "little to none" category, take this opportunity to add shares of one of the highest-quality banks.

Risks To Consider: Both stocks would be hurt if faster-than-expected inflation causes the Fed to raise interest rates more than two or three times over the next year.  

Action To Take: Buy American Electric Power below $66 and Wells Fargo below $53.

P.S. President Obama recently signed a new bill into law that makes it legal for 10 million Americans to have their retirement benefits slashed by 50% or more. You could be forced to forfeit as much as $25,000 of your annual income every year. Find out how to protect your wealth here.

Nick Lanyi does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.