How To Prepare For 6 More Months Of Fed Inaction

Nick Lanyi's picture

Thursday, June 23, 2016 - 12:30pm

by Nick Lanyi

Last year, Federal Reserve Board officials spent weeks telegraphing their first increase in short-term interest rates in years. When it finally happened in December no one was surprised. That's how it should be. 

The Fed's job is to manage the nation's money supply, in part by setting short-term interest rates, with a goal of balancing economic stimulus with inflation risk. If money supply is too loose, inflation can result; if it's too tight, one might see a recession. But any interest rate change can be disruptive, altering business plans at companies around the world. So the Fed moves best when it's deliberate and transparent, discussing moves for weeks or months before they happen. No surprises.

Last week's decision not to change interest rate policy was no surprise, though a rate hike had been telegraphed and expected just a few weeks ago. The unexpectedly weak May employment report forced the Fed's hand; the risk of recession if interest rates rise is too high.

While not shocking, the Fed's non-hike has significant consequences for stocks for the rest of the year. Here's why: the only other opportunities to raise rates will be at one of the three remaining Fed Board meetings, in July, September or December. I think a rate hike in September of a presidential election year is unlikely. As for July, it could happen if June's employment numbers are far stronger than May's. But if not, why would the Fed pull the trigger four weeks after staying put?

Thus, I think the most likely scenario is no rate hike until December, with the second most likely an increase of 25 basis points (0.25 percentage points) in July.

If the Fed doesn't raise interest rates -- or waits until December for the only hike of 2016 -- what types of stocks will benefit? I would focus on two interest-rate-sensitive sectors: utilities and homebuilders.

Utility stocks should continue to perform well. Late last year, I advised picking up shares of high-quality electric utilities after they had sold off in anticipation of a Fed hike. At that point, the risk of significant Fed tightening was remote; the correction in utility stocks had been too severe. That view turned out to be more or less correct; nine months later, we've seen only a 25-basis-point increase, and utility stocks have moved well higher: the Dow Jones Utility Index is up 22% since late September, not counting dividends.

Utility stocks are now valued at the point that a rate hike of more than 50 basis points before the end of the year would knock them down. Remember, these stocks hate rising interest rates because as regulated businesses, they tend to reward shareholders with above-average dividend yields -- funded by reliable cash flow from ratepayers -- rather than above-average capital gains (the record of the past nine months notwithstanding). When interest rates rise, bond yields go up -- making them more attractive for income investors than utility stocks. Higher interest rates also hurt utilities because they are capital-intensive businesses that need to borrow money to maintain or expand their massive and costly infrastructures.

Three of the highest-quality utility stocks are Dominion Resources (NYSE: D), Southern Company (NYSE: SO) and Xcel Energy (NYSE: XEL). I recommended them here; buy them on pullbacks.

Homebuilders also look promising. The housing market has suffered through a slow-as-molasses recovery since the financial crisis and the Great Recession devastated home values just as the industry had undergone massive investments to construct new homes. Although some regions have yet to recover fully, but overall the housing market looks healthier than it has in years.

Home sales are at multi-year highs, home supply has fallen steadily since 2008 and wages seem to be growing after years of stagnation. And the Millennial generation -- actually now larger than the Baby Boom -- is transitioning from renting to owning as more of them become parents. Not surprisingly, homebuilder companies are feeling more optimistic about the future; the National Association of Home Builders' builder sentiment index rose to a five-month high of 60 in June (a reading of 50 or above rates as “positive” sentiment).

Stable, near-zero interest rates have been a boon to the housing recovery, as historically low mortgage yields make homes more affordable. If the Fed pauses for the next six months, it's more likely that demand for homes continues to grow.

I continue to recommend D.R. Horton (NYSE: DHI) and Lennar Corp. (NYSE: LEN), the two largest U.S. homebuilders.

Risks To Consider: All of these stocks could suffer if interest rates rise faster and more sharply than I expect, and some investors consider the utilities sector to be overvalued.
    
Action To Take: Buy Dominion Resources, Southern Company and Xcel Energy on pullbacks. Buy D.R. Horton under $33.50 and Lennar Corp. under $47. 

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Nick Lanyi does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.