How to invest when the Fed raises rates

In the most recent version of Barron's printed magazine, Robert R. Johnson, the president of the American College of Financial Services, wrote a piece titled “Rising Rates Spell Trouble for Stocks”. In this feature Johnson states what many investors generally fear about the likelihood that the Fed later this week will start to raise short-term interest rates for the first time since 2006. 

“While some pundits are putting forth the argument that rate increases are actually good news for investors, because they signal the Fed's belief in a healthier economy, our findings suggest that equity investors would be well advised to lower their return expectations—or search for investment alternatives—as rates rise,” writes Johnson. “The empirical evidence is persuasive that rising rates have simply not been good news for the stock market."

Johnson, who has co-written a recently-published book entitled “Invest with the Fed: Maximizing Portfolio Performance by Following Federal Reserve Policy,” wrote in Barron's that “during a period of rate hikes, defensive industries such as food, energy, and utilities have performed better than most.” As for bonds, an asset class widely derided because of low rates, he points out something I found a little surprising: bond returns aren't dramatically different in expansive and restrictive monetary policy environments. “Treasury bonds returned 7 per cent per year during expansive periods and 6.3 per cent in restrictive periods from 1966 through 2013,” he writes, adding “during restrictive periods, investors would have been better off holding Treasury bonds, not large-cap equities.”

Interesting, Fortune magazine chose to take a cue from Johnson's research to lay out a case for which stocks can thrive in a coming period of Fed rate hikes. 

Writer Lauren Silva Laughlin pointed out that Johnson and his two co-writers concluded that while we are entering a restrictive period of monetary policy, “because the Fed has vacillated—it has ‘virtually no conviction around its move,' Johnson says—today's environment is more akin to what he calls an indeterminate period, when Fed signals are mixed and rates don't trend one way or another. “

Laughlin writes that “indeterminate periods,” it turns out, aren't rare. Roughly 17 of the 48 years covered by Johnson's study qualify. Better yet: Johnson and his colleagues have identified stock sectors and asset classes that have performed well in such murky conditions.

Fortune took their research as a jumping-off point, looking at sectors that thrived in indeterminate years.

For example, energy is the best-performing sector during indeterminate rate cycles, averaging a 15.3 per cent annual return; energy stocks also thrive when rates are rising, gaining 11.5 per cent.

“Both those rate climates correlate with a growing economy, which usually means more energy consumption,” Fortune's Laughlin adds. 

The problem, of course, is that the energy sector may be in deeper trouble than during past decades: a slowdown in China and overproduction elsewhere have created a huge oil glut, sending crude prices and the stocks of energy companies plummeting. 

But as producers cut production and demand improves with a stronger economy, prices could rebound.

“Until then, companies that can keep their costs down will fare best in a cheap-energy world,” writes Laughlin, whose piece mentions such explorers as Whiting Petroleum (ticker: WLL ) and EOG Resources ( EOG ). (Whiting Petroleum is among Clay Carter's international stock picks - see Eureka international stocks: New plans, December 2 2015).

The article also makes a case for financial stocks, which actually do better during indeterminate cycles, “returning 14.6 per cent annually, compared with 6.9 per cent in rising-rate climates. One reason for that disparity: Investors often crowd into the stocks in anticipation of rising rates, so stock gains come before the rate hikes do. “

The question of course is whether a tepid or indeterminate rate-hike campaign gives way to something more robust and, using Johnson's word, restrictive. 

Robert J. Samuelson, the Washington Post's veteran financial columnist, entertains that possibility in his column over the weekend. 

“Capital Economics, a consulting firm, predicts that next year's ‘big surprise will be how quickly inflation rebounds,' forcing the Fed to raise interest rates sooner and higher than it now expects, he writes. 

Fans of a more tepid Fed response can only hope that Martin Wolf, the Financial Times' chief economics commentator, is correct. 

Wolf has argued in past columns that the Fed isn't that worried about inflation because the official rate is low and thus would be loath to do anything that further strengthened the dollar at the expense of U.S. exporters.

*This report is republished with permission from Barron's.