Are You Ready For Rising Interest Rates? Here's Your Playbook

StreetAuthority Network

Let the jockeying begin. Strategists are predicting a major change in interest rates in 2014 and 2015, and have already begun to identify the fallout -- positive and negative -- on a wide range of stocks. As long as you follow the game plan, your portfolio is likely to benefit.

There are two extremely likely scenarios for 2014. First, the Federal Reserve is expected to keep the federal funds rate near zero, which will keep interest rates on shorter-term lending rates very low. Second, the Fed will ease off its massive stimulus program (known as quantitative easing, or QE), which is likely to allow long-term rates to rise to levels that truly reflect global economic activity. (The QE program has kept a lid on long-term rates.) I discussed this notion a few weeks ago in my look at the soon-to-change yield curve.

Historical trends suggest that certain sectors are likely to benefit while other sectors are likely to lose some appeal with investors. And even within sectors, clear winners and losers will emerge.

Not All Yield Plays Are The Same
First, let's get the obvious impacts out of the way. Any income-producing investments such as utilities, real estate investment trusts (REITs) and master limited partnerships (MLPs) are bound to suffer. The SPDR Select Utilities Fund (NYSE: XLU), for example, has lagged behind the broader market since May, when investors first sensed that the QE program would soon come to an end. Look for this trend to continue in 2014.

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In a similar vein, the JPMorgan Alerian MLP Index ETN (NYSE: AMJ), which tracks many of the country's high-yielding pipeline MLPs, has lagged the S&P 500 Index by more than 15 percentage points since May.

That doesn't mean that all yield plays will be shunned. As we've noted recently, companies with rising payouts will still hold appeal. Analysts at Merrill Lynch concur: "We prefer dividend growth stocks over simply high dividend yields as a good hedge against rising rates," they wrote in a June report.

In fact, the steepening yield curve will be great news for any companies holding significant cash balances. Higher rates should enable these firms to generate higher interest income, which I discussed in October. If you're looking for sectors with lots of cash, then the tech sector should be your focus. And tech stocks have a historically positive bias when rates are on the rise, regardless of cash balances. Merrill Lynch suggests that the 2014 rate scenario will be very similar to the scenario seen in 1994. Back then, rates rose higher in tandem with a slowly strengthening economy, and tech stocks rose 19%, the best gain for any sector. (Utility stocks fell 17% that year.)

Rising rates have historically been kind to energy stocks as well. That's because higher rates are often accompanied by higher rates of inflation, which are often correlated with rising energy prices. However, this link may not play out in 2014, as inflation is calmer than a bear in winter.

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Know Your Financials
While the playbook for many sectors is cut and dried, the strategy around bank stocks is more complex. Many banks have a much greater focus on short-term interest rates, while other banks are better positioned for moves in longer-term rates.

Right now, a number of banks such as Citigroup (NYSE: C) derive most of their net interest income (that is, the spread between their borrowing and lending costs) from the spread in short-term rates. In contrast, many regional banks are structured to generate most of their net interest income from long-term bonds. Goldman Sachs cites Regions Financial (NYSE: RF) as a clear beneficiary, as more than 60% of net interest income is derived from the spread between long and short rates.

Among the large banks, JPMorgan Chase (NYSE: JPM), with more than 40% exposure to long-term net interest income, is a Goldman favorite, adding that the bank "has the most inexpensive valuation in the group on 2014 and 2015 EPS."

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To be sure, the housing market stands as either a positive or negative for banks stocks as well. If rising rates (and higher mortgage interest rates) start to weigh on home sales, then profits from mortgage underwriting are bound to slump. Wells Fargo (NYSE: WFC) and Fifth Third Bancorp (Nasdaq: FITB) derive an outsize portion of their business from mortgage activities and appear most vulnerable to higher mortgage rates.

Then again, these banks have greater upside if the housing market delivers a better-than-expected performance in 2014. My take: The recent housing weakness is likely to persist for at least a few more quarters, but the outlook into 2015 and 2016 is far brighter.

Risks to Consider: If longer-term rates don't rise in 2014 in tandem with a pullback in the QE stimulus program, then investors will grow concerned that the U.S. economy remains distressingly weak. That's a negative scenario for the potential beneficiaries noted above and likely a positive for more defensive stocks such as utilities and MLPs.

Action to Take --> It's quite likely that the Fed will start tapering the QE program in the next three to four months -- if not sooner -- and you need to adjust your portfolio in advance. Stress-testing each portfolio holding in terms of interest rate sensitivity is an exercise you should begin soon, if you haven't already.

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