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How to Invest in a Declining Interest Rate Environment

Low interest rates could turn out to be a blessing for a certain group of investors and industries, but not so much for others, as there are a few sectors that particularly benefit from low rates.

In July, The Federal Open Market Committee decided to cut the federal funds rate by 25 basis points, making the third cut in a row. By adopting an expansionary monetary policy, authorities aim to provide a boost to the economy.


The general understanding is that equity markets tend to perform better when rates are low. This is due to the perceived inverse relationship between these two variables. However, Derek Horstmeyer, a finance professor at George Mason University, had the below to say about this development.

"Typically, equities across the board suffer in a falling interest rate environment - this is because the Fed only reduces interest rates when the economy is slowing or we are in a financial crisis."

To generate attractive returns in the prevailing macro-economic environment, investors need to have an idea about sectors and asset classes that are likely to perform better under these conditions.

Consumer staples companies

As per data from Investopedia, the consumer staples sector accounts for nearly 70% of the Gross National Product in America. Over the last 10 years, the performance of this sector has not been up to investors' expectations and has lagged the broad market, as measured by the return of the S&P 500 Index.

Source: Eikon

Even though the relative performance has been lackluster, things could see a turnaround in the next decade. This is because of the non-cyclical nature of this sector. Consumer discretionary sector companies thrived since 2008 along with the economic growth that prevailed in the U.S. However, as growth slows, these companies will likely find it difficult to continue with this momentum.

Source: Bureau of Economic Analysis

On the other hand, regardless of the business cycle, the consumer staples sector will generate consistent revenues. During a declining interest rate environment, the cost of debt will go down, resulting in a higher return on investment for these companies. Costco (NASDAQ:COST), Target (TGT) and Home Depot (NYSE:HD) are a few companies that benefited under similar conditions leading up to the last recession.

Investors preparing for the next recession or aspiring to build a portfolio to weather all market conditions should consider this sector.

Utilities

Utilities experience steady demand for their products and services regardless of the underlying macro-economic environment. These companies are also known for stable dividend payments. This characteristic ensures that investors receive income even if capital appreciation returns would be minimal due to unfavorable developments.

For instance, while treasury yields reached record lows between 2008 and 2010, utilities outperformed the other sectors, showcasing the inverse relationship of this sector with interest rates. This negative correlation adds diversification benefits to investors, which is a formidable reason to consider investing in utilities in preparation for the next rate-cutting cycle.

Source: Market Realist

Health care companies

The health care sector consists of multiple manufacturing industries, including pharmaceuticals and the medical equipment industry. The performance of this sector is mostly non-cyclical, as the demand for end products remains steady regardless of whether the economy is slowing or not. As evident from regulatory filings, health care companies obtain their capital mostly through fixed-rate or variable rate loans in order to carry out their general operations, renovations and expansions. Low rates provide the best opportunity to obtain capital at attractive rates, giving the ability to generate higher returns in the future.

For example, during the last recession in 2008, the debt level of these companies soared in order to take advantage of the cheaper cost of borrowing.

Source: Market Realist

Not surprisingly, the healthcare sector performed better than the broad market.

S&P 500 Index performance between October 9, 2007, to March 9, 2009 (peak-to-trough of the recession)

-56.78%

Healthcare sector performance between October 9, 2007, to March 9, 2009 (peak-to-trough of the recession)

-38.3%



Source: Eikon

The refinancing risk for these companies will reduce when interest rates are low as well, which would strengthen the balance sheet.

Going by historical records, investors need to invest in companies representing this sector to build a strong portfolio that can provide attractive returns when the macro environment is not supportive.

Commodities

Commodities also have an inverse relationship with interest rates, which is depicted by the below graph. The primary reason behind this phenomenon is the lower carry costs when rates decline.

Source: St. Louis Federal Reserve

This might be one of the reasons why gurus including Ray Dalio (Trades, Portfolio) have taken a special liking to gold. Investors should consider adding exposure to commodities, as historical evidence suggests that the future performance of these economic resources will be positive in recessions.

Mid-cap stocks

Mid-cap stocks, or companies with a market capitalization between $2 billion and $5 billion, tend to benefit when rates are low because they usually suffer from low access to capital when rates rise. Generally, banks and other financial institutes prefer to provide loans to large and growing companies when the economic growth is stellar, as small companies find it difficult to service debt payments issued at high rates. Growing but small companies tend to aggressively accrue debt as soon as the cost of borrowing declines, which eventually leads to a stellar financial performance.

Jodie Gunzberg, the chief investment strategist of Graystone Consulting, stated that since July 1997, when rates fell, the S&P 500 declined on average by 17.7% while mid-cap stocks [as measured by the S&P Midcap 400 Value Index] held up relatively well, losing just 6.7% on average.

Investors need to make sure that they do not base their investment decisions solely on the size of the company, but rather conduct a thorough due diligence process before reaching a conclusion.

Dividend-paying companies

Ron McCoy, the CEO of Freedom Capital Advisors, had the below to say about companies that regularly pay dividends.

"The power of reinvestment of the dividends over time can add up and help build up assets."

Since 1932, distributions to shareholders by companies have accounted for approximately 32% of the total equity return for U.S. stocks, while the capital gains have contributed around 68%, according to data from Standard & Poor's. The income distributed to investors helps an investment portfolio perform better when the possibility for stock price appreciations is limited.

A study conducted by Albert Williams and Mitchell Miller of Nova Southeastern University in 2010 reveals that dividend-paying companies performed much better than non-dividend paying companies in each stage of the full business cycle that lasted from 1990 to 2010.

Source: Nova Southeastern University

Investors with an objective of generating a steady income from their portfolios should certainly consider these types of companies, as dividends could turn out to be a solid alternative to fixed income securities.

Conclusion

If there's a lesson to be learned from the recessionary period during the financial crisis of 2008, it's that diversification plays a major role in determining the performance of an investment portfolio. The sectors that provided the best returns prior to the economic downturn shed most of those gains during the crisis while the underperforming sectors leading up to 2008 held much better.

Source: S&P 500 data

Considering that both the International Monetary Fund and the World Bank are predicting a slowdown of the American economy within the next 2-5 years, investors should be proactive and make the necessary changes to ensure the portfolios provide an acceptable return in this period.

Disclosure: I do not own any stocks mentioned in this article.

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This article first appeared on GuruFocus.