Your Essential Fed Hike Playbook

It’s nearly impossible to click through to Bloomberg or another financial news site without being inundated with analysis predicting the next rate hike by the Federal Reserve. 

Everything seems to be tied back to the potential for higher rates, and current 30-day Federal Funds futures put the odds at 65.6% that the central bank will hike by at least 25 basis points at its December meeting.

#-ad_banner-#Volatility has spiked several times this year on investor fears of higher borrowing costs. The VIX volatility index spiked 88% in June when economic reports suggested higher rates were coming. Volatility jumped again, rising 52% in the third week of September, and then did so a third time this month. 

All three surges in volatility have been met with a sell-off in stocks.

But investors may be missing one very important point about rate hikes. It’s something only the economists know and something that could change the way you invest over the next several years.

Understanding The Whole Rate Cycle, Not Just The Hike
The watch for higher rates has turned into a Wall Street nail-biter as the market rises and falls with each piece of economic data or speech by a member of the Fed. There is some rationale to the fear of higher rates. Researchers at Creighton University found that the S&P 500 returned 15.2% on average during falling rate cycles back to 1966 but only returned 5.9% when rates trended higher.

What investors seem to be forgetting is that rate cycles develop over time. The Fed doesn’t want to choke off growth completely by raising rates too fast. In the four rising rate cycles over the last 30 years, it has taken the Fed nearly 18 months to push the effective fed funds rate up by an average of 3%. 

This means that getting the exact timing of the next rate hike may be much less important than planning out what you will do over the entire rate cycle. Whether the Fed hikes in December or not, there is no doubt that rates will be moving higher and investors need to be ready with a longer-term playbook.

Bet On Banks Now
Banks have been getting hammered on historically low interest rates but could jump as higher rates lead to profitability. I like the consumer deposit banks because they will benefit more from interest income and the widening net interest margin, versus the capital investment banks which earn more on fees. 

Huntington Bancshares (Nasdaq: HBAN) is one of the largest banks in the Midwest, but it is still relatively small at a market cap just over $10 billion. Shares trade for 1.2 times book value, just under the average 1.3 multiple on the industry, and pay a healthy 2.8% dividend.

The bank began a strategic shift under new management in 2010 and has driven big gains in customer service and cross-selling. Nearly half (41%) of the bank’s commercial accounts use four or more of the bank’s products or services, up from 22% in 2010. Product usage among retail customers has also improved with 80% of individual accounts using four or more services, up from 68% in 2010.

Count On Insurers To Thrive During The Hikes
Insurers will be able to invest customer premiums at higher rates while the Fed is lifting borrowing costs. Increasing rates may weigh on the value of insurers’ bond portfolios but these bonds are generally held to maturity so the par value is still recovered when the bond expires.

This is especially true for life insurers, which have longer investment horizons and make money on the rate spread for annuities. Insurers are also less economically sensitive, which will be important if the economy does start to sputter against higher borrowing costs.

Prudential Financial (NYSE: PRU) is the second-largest life insurance company in the United States and the company has grown a significant business in Japan that accounts for 90% of international revenue. Shares trade for just 0.7 times book value, well under the average 1.1 multiple for the industry, and pay an attractive 3.3% dividend. 

Prudential was listed as a Systemically Important Financial Institution (SIFI) after the financial crisis, leading to higher capital requirements that could hold back growth. There is reason to believe the company may be able to overturn the decision given its strengthening balance sheet and the legal challenge won by MetLife earlier this year. Clearing the SIFI designation could mean a big pop in the shares on easier capital requirements and resulting flexibility in what the company can do with its cash.

Look To REITs For Post-Hike Gains
Real estate investment trusts (REITs) could sell off for months as the Fed hikes rates on these highly-leveraged businesses. The weakness could be a good buying opportunity on this asset class, which traditionally offers good price appreciation and strong cash flow. The FTSE NAREIT Equity Index has grown at a compound rate of 10% annually over the last 30 years, well above the annualized 7.9% increase in the S&P 500 over the period.  

It may take a year or more for REITs to settle after the rate-induced selloff so look to stagger your investment into the group. This will lower your cost basis and allow you to enjoy the longer-term recovery in a group that has produced excellent cash flow and returns.

Equity Residential (NYSE: EQR) may not suffer as much as other REITs on rising rates as higher borrowing costs also make home ownership more expensive and drive people to rent. The company has been selling non-core assets lately to reposition its focus on coastal U.S. markets where economic growth and demographics are more favorable. 

Booming student loan debt and a shift in demographic goals could mean apartment owners like Equity Residential enjoy decades of outperformance as millennials choose renting over home ownership. Overall home ownership in the United States is at 62.9% according to the Census Bureau. Home ownership by people under 35 years old has hit a record low of 34.1%, just barely half the overall average rate.

Risks To Consider: There is the potential for a hit to market sentiment when the Fed does start hiking rates, weakening all stocks before specific industries like those above rebound.

Action To Take: Understand how the rising rate cycle might affect particular industries and strategically plan your investments before, during and after the Fed moves.

Editor’s Note: There are other concerns roiling the markets now — such as the upcoming election. Economic turmoil historically follows nearly every newly elected president. In fact, Bush fueled a 78% Nasdaq collapse in 2002. So regardless of who wins on November 8… you MUST take steps to protect your portfolio today. Click here to discover three POTUS-Proof industries to play for up to 200.6% profits…