What to buy when interest rate hikes take hold

Share

Interest rate hikes by the U.S. Federal Reserve will define stock market activity in 2015, eroding valuations, ending double-digit returns and presenting a large obstacle to anyone with dreams of outperforming major indexes, according to a strategy report from Goldman Sachs.

But if you're okay with 5 per cent gains, then the year ahead won't look bleak at all.

"The U.S. economy will expand at a brisk pace," said strategist David Kostin in his 2015 outlook.

"Corporations will boost sales and keep margins elevated allowing managements to both invest for growth and return cash to shareholders via buybacks and dividends. Investors will cheer these positive fundamental developments."

The problem, he said, is that rising interest rates will follow these improvements as the Fed recognizes that the U.S. economy is strong enough to survive baby steps toward a more normal monetary policy.

The Fed has left its key rate close to zero per cent for the entire economic recovery, and has only recently ended an extraordinary program of buying $85-billion (U.S.) worth of bonds per month.

This stimulus has helped drive one of the longest bull markets on record, lifting the benchmark S&P 500 by more than 200 per cent from its multi-year low in 2009 – but has raised questions about how the market will react once the stimulus is withdrawn.

Mr. Kostin has some answers.

He thinks the Fed will start raising rates in the third quarter, driving the yield on the 10-year bond to 3 per cent, up from a little over 2.3 per cent on Thursday. The Fed won't halt there, but rather raise rates steadily through 2018, weighing on bond returns.

"We expect a benign equity market reaction to the first Fed rate hike," Mr. Kostin said, pointing to the Fed's transparency in timing the shift.

Nonetheless, the stock market will adjust to the shifting environment in a couple of ways.

For one, he expects valuation multiples will contract. The S&P 500 has averaged gains of 17 per cent over each of the past three years, or well ahead of earnings growth. That has caused valuations to surge from 10-times estimated earnings to 16-times estimated earnings.

Early gains in the stock market next year will drive the price-to-earnings ratio up to 17, but rate hikes will send the ratio back to 16 – putting the S&P 500 at the mercy of earnings growth alone. That is why Mr. Kostin believes the index will rise a modest 5 per cent, to 2150.

The other impact will come in the form of low volatility. Historically, low volatility tends to depress the ability of stock pickers, including mutual fund managers and hedge funds, to outperform the market.

"Many fund managers disagree with our view and believe higher equity volatility will accompany higher interest rates," Mr. Kostin said. "They argue that once the Fed begins to hike uncertainty will abound regarding the pace of further tightening and volatility will jump."

However, he believes the hikes will be steady, shallow and well-telegraphed, taking the key rate to just 3.9 per cent within the next three years.

Bonds will struggle to return anything to investors during this period, making even low-returning stocks the best place to look for performance.

Mr. Kostin has three ideas for getting a little more than 5 per cent gains though.

One, buy U.S. stocks that generate most of their sales from the domestic market, given the relative strength of the U.S. economy over Europe and Japan. These stocks include Wells Fargo & Co., CVS Health Corp., AT&T Inc. and the railroads.

Two, focus on stocks that return cash to shareholders in the form of dividends and share buybacks. He estimates that dividends for companies within the S&P 500 will rise 8 per cent next year and buybacks will jump 18 per cent.

Some stocks that fit this strategy: Apple Inc., Corning Inc., FedEx Corp. and Viacom Inc.

Three, buy so-called illiquid stocks, or those stocks that trade relatively infrequently relative to the number of shares outstanding. The reason: professional investors are paying a premium for stocks they can easily sell at a moment's notice, making illiquid stocks a better buy for long-term investors who aren't as skittish.

These stocks include Philip Morris International Inc., Chevron Corp., Loews Corp. and General Electric Co.