The Markets That Could Inherit A Fortune From Rising Interest Rates

Carl Hazeley

5 months ago4:14 mins

The Markets That Could Inherit A Fortune From Rising Interest Rates

The US Federal Reserve (the Fed) just gave its biggest hint yet that it’ll be raising the country’s interest rates this year, but it needn’t be the catastrophe that the stock market’s performance this year suggests it will be. Because no matter how many times the central bank hikes rates in 2022, there are places, stocks, and sectors you’ll be able to keep profiting from.

The place to invest: Europe

The Fed has been on eight “hiking cycles” since 1975, and the way stocks have responded to them each time gives clues about what will happen this year.

Red lines indicate Fed hiking cycle
Red lines indicate Fed hiking cycle

There’s good news for Europe: the region’s stocks have historically delivered positive returns when the Fed increases rates, particularly in the six months after the first hike. European stocks rise 9% on average in that six-month period.

Returns pre and post first rate hike
Returns pre and post first rate hike

For what it’s worth, US stocks are no slouch either, historically rising about 5%. But European stocks overall are trading at a 27% discount to American ones, versus an average 15% discount prior to the last three hiking cycles. In other words, there’s a much bigger opportunity in buying European stocks as the Fed hikes rates.

The assets to invest in: value stocks

Value stocks tend to outperform growth stocks too – by about 3% in Europe. That’s perhaps to be expected: higher rates narrow the gap in returns between the riskiest and least risky assets out there, so investors may sell off their riskiest, most expensive stocks – which tend to be growth stocks – in favor of now higher-returning safer bets.

At the same time, high inflation – which is part of the reason rates are rising in the first place – tends to benefit value stocks. That’s because if companies whose shares look cheap versus profit forecasts can successfully pass higher costs onto consumers via higher prices, they could see both their profits jump and their stock prices shoot up in reflection of their now-higher earnings profile.

And the icing on the cake is that value stocks are also currently around 50% cheaper than growth stocks in Europe – twice the discount before the previous three hiking cycles.

The industries to invest in: energy and banking

Energy, real estate, and basic resources are the best sectors to own during Fed hikes, but you might want to avoid defensive sectors like utilities, telecoms, and consumer staples.

Financials are generally a no-go too, having underperformed by the most of any of them. That’s because the gap between short-term US government bond yields and long-term yields usually narrows during hiking cycles, making it harder for banks to earn a profit. But this time should be different: eurozone interest rates are currently negative, so any rise should be positive for banks’ earnings.

Sector performance relative to the market
Sector performance relative to the market

Coupled with a bet that value will outperform growth, that suggests you’ll want to buy into financials and energy stocks. And the timing couldn’t be better: European stocks versus the US are lagging in the rotation to value from growth.

US vs Europe

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