Notes on an Interest Rate Rise

On December 16, the Fed raised the federal funds rate by 25 basis points. If you aren’t totally clear on what this means for investors, let’s review (if you are already clear on this, skip to the next article where we discuss some of our favorite stocks for a rising rate environment).

The rate that the Federal Reserve (the Fed) controls is called the Federal Funds Rate, which is essentially the interest rate at which banks can borrow from each other. Any increase in this rate gets passed along to consumers and businesses that borrow from banks. So while the Fed doesn’t directly increase the rate at which it costs to, say, get a small business loan, it does push the first domino in the chain.

Why raise rates? To counteract inflation in a fast growing economy. Essentially the Fed raises rates to prevent the economy from overheating, because even though a sluggish economy is bad, excessive economic activity can actually be equally bad. Ideally, inflation occurs roughly in step with the rate of economic growth. As you probably know, since the Great Recession, the Fed has kept interest rates at about the lowest-possible lows, between a quarter of a percent and zero, but our economy has since stabilized. Inflation hasn’t yet been a problem (largely due to exceedingly low oil prices), but it is a concern, because super-low rates in a healthy economy could promote more lending/borrowing activity than is supported by the growth of our actual collective wealth (gross domestic product), which leads to the currency losing value. This is why the Fed has been eyeballing a rate increase for many months now.

A recent article in the New York Times likens an interest rate increase to “a doctor’s decision that a patient is well enough to be gradually taken off medication.” It’s difficult to predict exactly how the patient (our economy) will fare in the short-term during this process, because interest rates affect a broad array of economic activities that interact dynamically with each other. The last time rates this low were raised was in 1941, which was a very different context from the present one, so it doesn’t provide the most useful precedent. Nonetheless, there are certain results that we can reasonably anticipate, even if we can’t know how pronounced they will be or what the total combined effect will be:

• A general decline in lending activity, both to consumers and businesses, because of the increased cost of borrowing. This is what the rate hike is intended to do: provide some healthy friction on a growing economy.
• A higher rate of return on safe and “risk-free” investments such as treasury bonds, meaning these instruments become more attractive relative to stocks. The incentive to save money is increased.
• The already-strong U.S. dollar is likely to become stronger. This is due to multiple factors such as an increased demand for government-issued bonds and bills (per the above point), an increase in foreign investment in the US, and an increased demand for dollars in general because debt issues are fetching higher interest.
• Government debt interest payments increase. Higher rates increase the cost of government interest payments, which could eventually hit consumers in the form of higher taxes.
• Debt with a variable interest rate becomes more expensive. Those with variable rate mortgages will have less spending power.

The degree of these effects will depend on the Fed’s pacing (we have only just experienced the first increase in a series of gradual steps) and the actual resilience of various industries, plus a bunch of X factors like oil prices, weather, and international politics.

Takeaways for Investors

As you can see, one simple rate change can have wide-ranging results. For anyone who invests in equities, there are a few takeaways:

• Sales in many industries may be down for several of the reasons outlined above that lead to decreased discretionary spending. (However, this may be counteracted by the “rising tide” of a growing economy.)
• Variable interest rate debt becomes more expensive. Companies with cleaner balance sheets have an edge. Companies with a trend of rising debt or a lot of debt where the interest rate is variable should probably be avoided.While some companies disclose the types of bonds aka notes they have in their 10K, most do not. Thus investors are probably better off sticking to firms with sound balance sheets that have low or decreasing debt.
• A stronger dollar hurts exporters and also means that revenue from sales generated abroad will be slightly blunted by exchange rates.
• Company valuations that incorporate future expected cash flows will be reduced. This is because, for many companies, future expected cash flows will become lower due to an increase in debt expenses or a decrease in sales, or both. Accordingly, stock prices and therefore indices will probably come down.

Most of that sounds like bad news for investors, but don’t forget that the Fed is raising rates because it feels the economy is on a strong-enough upward trend that includes decreasing unemployment, increasing discretionary spending, and more housing starts. So you could end up with different stock picks based on whether you emphasize the ”economy is improving“ element or on the ”rising rates will hurt“ element.

For us at Stock Rover, we know that, as in any economic environment, we want to invest in quality companies. Given the context of the rising rate and healing economy, here is what we at Stock Rover are looking for in stocks right now:

• Low debt or a decreasing debt trend, and a clear ability to service debt.
• Positive and increasing cash flow and free cash flow. (Exceptions can be made for well-run companies who have made recent long-term investments.)
• Sector preference goes to financial services, followed by consumer cyclical (AKA discretionary), technology, and industrials—all of which have the potential to benefit in this environment. Sectors such as consumer defensive (AKA staples), utilities, and healthcare are unlikely to be harmed by the rate hike.

We’ve picked 11 stocks we like right now that meet this criteria. Jump to the next post to see them!