What Stocks May Do Well As The Fed Tightens

He wasn’t kidding. Jerome Powell, chairman of the Federal Reserve Board, said Friday that the Fed’s Open Markets Committee will “use our tools forcefully,” and keep raising interest rates until inflation comes down. This is “no place to stop or pause,” he said.

Investors winced, and stocks tumbled. The so-called Fed “pivot” was revealed to be just wishful thinking. Inflation is a stubborn foe: I think it is unlikely to be conquered before 2024. So it would be wise to look for stocks that can do well when interest rates are rising.

Banks

There are many cross-currents, but generally rising rates are good for banks. If a bank borrows at 2% and lends at 4%, it makes roughly $2,000 a year on a $100,000 loan. But if it borrows at 3% and lends at 6%, it makes about $3,000 on the same sized loan.

So far this year, bank stocks have done poorly. Bank of America
BAC
is down 26% through August 26. Citigroup
C
is down 21%, JPMorgan Chase (JPM) down 29% and Wells Fargo
WFC
is down 13%.

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Investors worry that a recession has begun, or soon will. That could mean that banks make fewer and smaller loans, and suffer more loan defaults. Nonetheless, I think some bank stocks are good buys at current prices. JPMorgan, one of my favorites, sells for only nine times earnings.

Insurance

Insurance companies receive premiums today, and pay out claims tomorrow — or much later. In the meantime, they invest the premium money (float), often in bonds.

As rates rise, the value of existing bonds automatically declines, and that hurts insurers. But new float can be invested at higher rates, and that’s good.

Some insurance stocks selling for what I consider reasonable prices are MetLife
MET
at 16 times earnings, Travelers Companies (TRV) at 12 times earnings, Hartford Financial Services Group
HIG
at 11 times earnings, and Principal Financial Group
PFG
at five times earnings.

Energy

When the Fed raises rates, it usually does so because it sees inflation as a problem. Energy costs are a key part of the inflation picture. High oil and gas prices are a problem for consumers and businesses, but obviously are a boon to energy producers.

Even in recessions, energy demand often stays stable or rises a bit. And energy supply is currently reduced because of the Russia-Ukraine war, and sanctions against Russia by the U.S. and its allies. So, I would expect energy prices and profits to stay strong.

This year through August 26, ExxonMobil (XOM) is up 54%, ConocoPhillips
COP
has gained 52%, Chevron
CVX
has risen 37%, and Shell PLC (SHEL) has advanced 23%.

TotalEnergies SE (TTE), based in France, has lagged (up only 5%) because of its closer ties to Russia. I favor it, however, because it’s cheap at less than eight times earnings, and because it has large-scale projects in solar and wind energy.

Healthcare

Health care stocks – drug stocks in particular – usually hold up well when the Fed goes on a rate-raising campaign. Much health care spending is non-discretionary. Very little of it is paid for by borrowing: Medicare, Medicaid and private health insurance cover most of the bills.

So far this year, Merck & Co.
MRK
and Eli Lilly
LLY
are both up 16% and Bristol-Myers Squibb (BMY) has gained 15%. AbbVie
ABBV
is roughly flat, and Johnson & Johnson
JNJ
has dropped 4%, while Pfizer
PFE
has trailed competitors with a 17% loss.

I like most of these stocks (and own two of them) but I would avoid AbbVie because its debt-to-equity ratio is high.

What’s Harmed

Real estate investments have historically done poorly when the Fed is tightening (i.e. raising rates). Home buyers and commercial developers need mortgages to pay for new buildings, and the higher the mortgage rates go, the harsher the headwind.

I’ve owned homebuilding stocks until very recently. I think many of them are better run than they used to be, and I believe there is pent-up demand for single family homes. But now, with the mortgage problem, I suspect they will be no better than market performers, so I’ve pretty much sold out.

Disclosure: I own Merck, Pfizer and TotalEnergies personally and for most of my clients. Some of my clients own Chevron, Exxon Mobil, Johnson & Johnson, JP Morgan and Met Life. A hedge fund I manage has a short position in Wells Fargo (we profit if the stock declines).

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