What to buy when rates go up

Did you know that when interest rates start to go up, certain types of stocks do better than others?

Did you know that when interest rates start to go up, certain types of stocks do better than others?

It’s true. (Although it’s been 12 years since the start of the most recent “tightening cycle”. So you could be forgiven for being a bit hazy on the details.)

We’re finally at a point where Mark Carney is starting to think about raising rates. The US had its first interest rate rise since 2008 earlier on this year.

Mark Carney and the Bank of England tend to be less strict about raising rates than their counterparts at the Fed. So in the UK, interest rates probably won’t go up in the next quarter or two. But go up they will!

Unemployment is low and inflation is just starting to creep up. Core inflation, the inflation measure central bankers tend to focus on since it strips out the volatile prices of imported stuff like food and energy, is up to 1.5% from 0.8% this time last year.

Core and headline inflation on the up
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When core inflation hits 2%, which is the bank’s official target for CPI, it will have to seriously consider raising rates. And when CPI hits 2% it’ll have no excuse.

This rate hike might not happen any time soon – in fact, it probably won’t happen until 2017 at the earliest. But as the chart shows, it’s coming. Today I want to talk about what you should do when it does.

Investing turned on its head

There’s some new research from academics at the University of Cambridge and London Business School which shows what happens to stock prices when interest rates go up.

The research is based on almost a century’s worth of returns in the US and the UK. I went out to Mayfair earlier on this year to see them present their findings.

Their research covered different asset classes, over a long time, in different countries. But the overall takeaway was this: when interest rates start to rise, the world of investing gets turned on its head. The interest rate cycle has a big effect on returns from different types of assets.

Take stocks, for example. Everyone knows that stocks tend to have bigger returns than bonds in the long run. But this research found that almost all of that “premium” over bonds is concentrated on times when interest rates are falling. When rates start rising, the premium over bonds drops from 5.5% to 1.9% in the US.

The types of stocks you own matters a lot too. Stocks in “defensive” sectors gain when rates are going up and fall when rates are going down. So when Mark Carney finally pulls the trigger, you want to be owning: utilities, telecoms, energy, healthcare, and business equipment stocks.

The sectors which perform worst when rates are rising, and best when rates are falling, are consumer durables and retail.

How did they calculate these numbers? Well the researchers compared prices before and after rate hikes were announced. That’s useful for you because it means the research is useful in real time – you don’t need to worry about market expectations of a rate hike for these results to be useful. You can just trade once the rate hike is confirmed.

We’re not there yet – the market thinks the first rate hike in the UK might be a while away yet. But forewarned is forearmed!

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