7 Stocks to Buy as the Fed Raises Rates
The Federal Reserve just made it official. After months of talk, rumors, and speculation, the Fed finally raised interest rates by 25 basis points. This has all sorts of investing implications including putting some new stocks to buy on the radar.
The interest rate hike marked the first increase of the bank’s key baseline interest rate since December 2018. In general, interest rate hikes may be associated with a weaker stock market.
As the Fed makes lending more expensive, it tends to put a drag on certain parts of the economy. If the Fed’s hike was a one-off move, that’d be a minor event. However, Fed chair Jerome Powell suggested that we should expect to see additional rate increases at just about every Fed meeting this year.
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With rate hikes stretching out as far as the eye can see, what will it mean for investors? While this tightening of monetary conditions will certainly cause problems for some sectors, there will be big winners as well.
These seven stocks to buy should profit as the Fed raises rates:
Charles Schwab (NYSE:SCHW)
Wells Fargo (NYSE:WFC)
U.S. Bancorp (NYSE:USB)
Metlife (NYSE:MET)
Aflac Insurance (NYSE:AFL)
Public Storage (NYSE:PSA)
TradeWeb (NASDAQ:TW)
Stocks to Buy: Charles Schwab (SCHW)
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Charles Schwab is a leading discount brokerage firm. Investors might wonder how brokers make money nowadays, given that rivals like Robinhood Markets (NASDAQ:HOOD) have just about eliminated commissions altogether. Meanwhile, other brokerage practices such as payment for order flow have become deeply controversial.
However, a core profit avenue for firms like these is through earning interest on customer deposits. Investors generally don’t pay too much attention to the level of interest being earned on cash sitting in their brokerage account. After all, the focus is on the stocks and other financial assets owned, not the cash that is just sitting around between trades.
But that cash has a lot of value. As interest rates finally rise off of the zero bound, it should be a huge opportunity for Schwab. It gets to invest that customer cash in short-term risk-free instruments such as Treasury Bills. If the interest rate on this risk-free paper rises from, say, 0.1% to 2.0%, that would allow Schwab to earn hundreds of basis points of interest on billions upon billions of dollars of idle cash.
Analysts see Schwab’s earnings soaring next year, bringing its forward P/E ratio down to 19.
Wells Fargo (WFC)
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There’s a good case to owning most of the too-big-to-fail banks in a rising interest rates environment. Most of their lending operations benefit from higher interest rates and larger interest rate spreads in one way or another.
Drilling down on specific banks though, Wells Fargo should be one of the more pronounced winners from a higher interest rate environment. Wells Fargo is one of the nation’s largest mortgage lenders and thus earns a large portion of its earnings from that line of business.
The housing market has enjoyed a robust period of growth since Covid-19 as people have looked to improve their living quarters. Some bears have suggested that the Fed’s rate hike campaign will hurt the housing market. And, at some point, if mortgage rates rise far enough, that may well happen. For now, however, the housing market still looks strong.
And while interest rates are surging, that means that the value of these newly originated loans will rise for the mortgage lending leaders such as Wells Fargo.
U.S. Bancorp (USB)
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U.S. Bancorp is another of the national banks with a strong franchise in the mortgage business. In addition to the same sorts of benefits that Wells Fargo should see there, U.S. Bancorp has another couple of things going for it.
For example, it has one of the highest operating efficiency ratios of the national banks, meaning it runs its operations at a lower cost than rivals. This has been essential to grind out sufficient profits even during a low interest rate margin environment. Now, with lending margins set to improve, U.S. Bancorp should be able to pass those new revenues through to bottom-line profits since it does such a good job of managing expenses.
The bank is also known for its strong deposit franchise. This means that it is able to attract lots of customer deposits per branch at attractive interest rates. This has been less valuable in a zero interest rate world, since people expect to get close to zero percent interest rates on their savings and checking accounts.
As rates rise, however, banks will have to pay more to keep depositors from moving their funds elsewhere. U.S. Bancorp, with its strong deposit network, should fare better than most banks as this competition intensifies.
Stocks to Buy: Metlife (MET)
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There’s another category of financial companies that benefit from higher interest rates. That would be insurance companies. The basic business model for insurers is generally to try to break even or make a small profit on the actual insurance policies.
The profit center is not in the insurance contract itself, but in getting to invest customer premiums over the years. On a typical life insurance policy, for example, it could be many decades between when the customer buys the contract and when the benefits are paid out. Metlife invests those premiums in a mix of stocks, bonds, and other financial assets and generates profits from its investment portfolio.
In recent years, however, the profit on bonds has declined sharply. With interest rates at such low levels, it’s hard to generate adequate returns from this part of the portfolio. And, unlike other investors, insurance companies can’t simply ramp up their risk exposure in stocks or other more speculative assets, since they have to comply with strict regulatory guidelines. On the liability side of the equation, however, an insurance company’s obligations tend to remain similar even as the profits earned from the bond side of the investment portfolio has declined.
Adding all these facts together, and some insurance companies have seen their valuation ratios decrease in recent years. Investors haven’t wanted to lock up capital in firms that seem to be prone to underperform. Now, though, with interest rates finally coming back to life, insurers like Metlife may get out of the penalty box.
MET stock has advanced nicely in recent weeks as optimism is starting to build. Even so, shares are still trading at just 0.9x book value; it’s a bargain to get a well-run insurance firm under book value. On top of that, shares are going for less than 9x forward earnings and offer a nearly 3% dividend yield.
Aflac Insurance (AFL)
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Aflac is another large insurance company. It offers a wide range of policies spanning life, autos, short-term disability and more. The company is famous for its Aflac duck commercials, but beyond that memorable marketing campaign, there’s one of the world’s most established and well-run insurance firms.
Aflac’s excellence over the decades can be shown by its dividend policy. The insurance giant has raised its dividend for 40 consecutive years, making it one of the dividend aristocrats. It’s especially impressive to pull off this sort of feat in an industry like insurance, where things such as natural disasters, pandemics, and terrorist attacks can ruin a company’s prospects in the blink of an eye.
However, Aflac’s diverse lines of operations, which includes both the mix of insurance products and geographies served, makes it able to withstand economic shocks. And now, thanks to the interest rate dynamics described above, Aflac should enjoy a period of stronger profitability.
AFL stock isn’t quite as cheap as Metlife, but it is at 10x earnings and a modest premium to book value, which is not a bad deal at all given the favorable outlook for the industry.
Public Storage (PSA)
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Public Storage is a real estate investment trust focused on the self-storage industry. It is America’s largest operator in that field, as it has been building and acquiring storage units for decades.
It serves as an interesting inflation hedge, as it owns one of the largest land banks in the country with its properties scattered around urban locations in many of America’s most important cities. If and when property values rise in a neighborhood, Public Storage can sell one of its storage properties to a developer of apartments or other higher uses and earn a fat profit on the underlying land in addition to the cash flow generated over the years from storage.
Public Storage isn’t just an inflation play, though. It also has a unique way to profit from higher interest rates. That’s because Public Storage primarily funds its balance sheet with fixed interest rate preferred stocks. A typical Public Storage preferred might offer a 4% interest rate, and it never matures.
That’s the key point right there. Public Storage can leave these preferred stocks outstanding until the end of time as long as it pays the 4% interest rate to holders every year. In a zero percent interest rate world, paying 4% on debt wasn’t particularly compelling.
If interest rates really get cooking to the upside, however, Public Storage will be funding itself with incredibly cheap capital. That should give it a huge competitive advantage as its rivals would have to refinance their traditional loans at far higher interest rates.
Public Storage has been playing the long game with its unorthodox funding strategy. Some analysts had urged it to issue cheaper debt instead of its preferred stocks. However, as interest rates soar, Public Storage will be in the catbird seat among the REITs.
Stocks to Buy: TradeWeb (TW)
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TradeWeb is a leading digital platform and marketplace for trading financial instruments such as corporate bonds, government bonds, and agency bonds. The business is one that is reliant on volumes to a significant degree; as trading activity picks up, TradeWeb should be able to earn more money.
That’s exactly what Bank of America’s analyst Craig Siegenthaler expects to happen. Siegenthaler notes that the conflict in Ukraine and its associated impact on commodities and interest rate markets is causing rising trading volumes across a wide range of financial assets. This will benefit the marketplaces such as TradeWeb that facilitate this increased trading.
And TradeWeb’s competitive position is particularly unique since it primarily targets the bond market. Bonds have been one of the slower fields to transition to digital trading, meaning that there is a larger market left to convert to TradeWeb’s software solutions. Throw in a massive interest rate hiking cycle and mounting geopolitical uncertainty, and this could be an excellent year or two for TradeWeb in terms of market adoption.
On the date of publication, Ian Bezek held a long position in PSA and WFC stock. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
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