The Federal Reserve is all but certain to hike interest rates this summer for the first time in four years. After months of strengthening economic data, the bond market is now projecting at least a quarter point hike in rates at the Fed’s June 30th meeting. And unless the economy suddenly falters, you can expect additional hikes later on this year.

The Fed controls an interest benchmark known as the Fed Funds rate; this is the rate you hear about on the news when there’s talk of Greenspan cutting or hiking rates. Changes in the Fed Funds rate, in turn, influence other interest rates, including those on government bonds and home mortgages.

There’s no shortage of pundits willing to predict just how aggressive the Fed will be this year. Historically, however, the bond and bond futures markets have offered the most unbiased projection.

To get a detailed picture of market expectations, look to the Fed Funds futures market. By comparing futures rates for different months we can estimate the size of expected hikes over time. The December 2004 Fed Funds futures are trading at about 2.125%. With the current rate at 1%, that suggests the Fed will implement about 112.5 basis points (1.125%) worth of increases this year.

But this shift in the central bank’s bias is hardly surprising. After a long series of cuts, rates are at the lowest level since the Eisenhower Presidency over 50 years ago. That leaves little maneuvering room for the Fed.

What’s more, this unprecedented easing campaign was designed to stimulate an economy buffeted by numerous economic headwinds, including a burst bubble in tech stocks and the Sept. 11th terror attacks. Those headwinds are now dissipating and the US economy looks to be on the mend.

Employment has begun to show signs of strength, even in the battered manufacturing sector (see our chart below). Corporate earnings and consumer spending too have ticked higher in recent months; that’s prompted a significant recovery for stocks.

This recovery hasn’t gone unnoticed at the Fed. In speeches by various officials, the central bank has made it abundantly clear that it is concerned that ultra-low rates might spark inflation. The Fed has all but spelled out its intentions--look for a slow but steady rise in rates over the coming quarters.

The Market and Rates
Just because the Fed is turning hawkish doesn’t mean you should sell all your stocks. Contrary to popular belief, periods of rising interest rates aren’t usually a disaster for the market. The Fed started hiking rates in 1994, ending a stimulus campaign designed to pull the U.S. economy out of the 1990/91 recession. In the 12 months following the Fed’s first rate increase the S&P 500 returned over 10%--hardly a bloodbath.

However, rising rates and shifting Fed policy do affect stocks and sectors in important ways. Historically, rising rates have caused sector rotation--institutions shift money out of so-called "interest rate sensitive" sectors and into more stable, defensive groups. That spells myriad opportunities for investors who understand how and why that rotation occurs.

Check out our bar chart below. This graphic reviews the performance of a few key sectors immediately before and during the Fed’s 94-95 rate hike campaign. There are some key similarities between this period and today. In both cases, for example, the Fed began to raise rates as the economic recovery took hold. And back in 1994, like today, bond yields rose sharply as expectations for future hikes mounted.

The Losers -- Banks, REITs and Utilities
Banks make money by attracting short-term deposits from consumers and lending that money out at higher long-term interest rates. Therefore, the level of rates isn't all that important to banks. Instead, they make money on the spread between long and short-term rates.

When the Fed hikes interest rates, short-term rates tend to rise more quickly than long-term rates. That means banks have to raise rates offered on money market funds and savings accounts, paying more to attract depositors. In these periods, banks' cost of deposits tend to rise faster than their profits from lending, thus leading to a profit margin squeeze.

REITs and utilities also usually underperform during periods of rising rates, but they do so for different reasons. First, investors tend to purchase both groups as income investments because they offer high dividends. However, when rates rise, bonds begin to compete with dividend-paying stocks for investors’ attention.

Secondly, rising rates raise the cost of borrowing money. REITs are prohibited by law from retaining more than 10% of their annual earnings--they must pay the rest out as dividends. That makes most REITs heavily dependant on debt to fuel expansion and new property acquisitions. With this in mind, it’s a small wonder that the average stock in the Morgan Stanley REIT index sports a debt-to-equity ratio in excess of 300%. As the Fed begins to hike rates, these companies will be forced to pay an ever-expanding interest bill.

The same goes for utilities stocks. Although many utilities are now working hard to clean up their balance sheets, most still carry above-average debt loads. The average company in the Philadelphia Utility index sports a debt-to-equity ratio in excess of 150%.

The Winners -- Pharmaceuticals, Consumer Staples
The Fed normally hikes rates when the economy begins to expand too rapidly--overly rapid expansion can fuel inflation. Higher rates serve to cool the economy, as businesses are simply more reluctant to borrow money and fund expansion.

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The effect on consumers is even more drastic. Many consumer purchases are funded at least partially by debt. That includes big-ticket items like cars, houses and jewelry, as well as smaller purchases like computers and furniture. Higher financing rates usually deter spending on such items.

But pharmaceuticals aren’t overly sensitive to either economic cycles or debt levels. Demand for healthcare products and services doesn’t change much from year to year, even during severe recessions. And while most Americans finance car and home purchases, drugs and doctor visits are covered by medical insurance; few go into debt to finance these costs.

There’s also another big kicker for the pharmas: demographics. The U.S., like most developed nations, is rapidly ageing as birth rates drop and life expectancies rise. Because older Americans require more drugs and medical services than their younger counterparts, we expect to see a secular rise in demand for all sorts of healthcare products in the coming years. It’s hardly surprising that during the depths of the 2001 recession the S&P Healthcare sector was the only major group to maintain double-digit earnings growth.

The other sector worth mentioning is consumer staples. As with the pharmaceuticals, basic staple products are insensitive to consumer debt burdens (clearly, very few people finance purchases of beverages and food). In addition, if the economy were to slow down in the coming years, then this wouldn't be a problem either--demand for most staples usually remains steady throughout both good times and bad.

How To Play It
In the table and text below we’ll take a closer look at several companies that should perform exceptionally well in a rising rate environment. Our picks all share the two characteristics key to profiting in a rising rate environment: low debt burdens and stable, reliable earnings growth.

In the pharmaceutical group we pay careful attention to patent expirations. Big drug companies depend on patent-protected drugs for the majority of their earnings. Just a handful of patented “blockbusters” need to finance all the R&D and failed trials these companies must endure. However, patents eventually expire, and that eventually erodes profitability. With this in mind, it’s a good idea to focus on companies with minimal patent expiration issues.

On the consumer staples side, we look for well-recognized brands with large market share. Strong brands dominate retail shelf space and command far higher prices than less-recognized names.

Important Note: To view an analysis of our favorite picks in the pharmaceutical and consumer staples sectors, you'll need to read the June 8, 2004 issue of our premium Market Advisor newsletter.  If you haven't already subscribed to this newsletter, please visit this link to gain immediate access to this premium content.

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