Navigating Stocks in a Higher Rate Environment: Sector Rotation Strategies

The New Interest Rate Reality

The COVID-era zero interest rate policy (ZIRP) was a key foundation for the massive stock market surge during the 2020-22 period. The subsequent inflation caused a Federal Reserve interest rate hiking cycle and concomitant stock selloff. Despite inflation being subdued and close to the Federal Reserve’s 2% target, longer-term interest rates are still in the 4.5% range and significantly higher than during the stock market boom of 2020-22. According to FirstRate Data, most analysts believe interest rates will be range-bound between 4% - 5% for the next few years and so the question arises what is the impact on the new higher-interest rate regime on the stock market.

The Impact of Interest Rates on Stock Prices

Broadly, there are two effects of higher interest rates on stock prices, which both act to lower prices. Firstly, stocks are valued based on their future profit cash flows. The way these future cash flows are valued in the present day is to discount them using the interest rates as the discount factor; a higher interest rate results in higher discount factors being applied to the cash flows, resulting in a lower valuation and share price.
In addition, the higher interest rate has a direct economic impact, which suppresses overall demand as financing for both consumers and businesses becomes more expensive.

Winners and Losers in a Higher-Rate Environment

The first major sector which suffers in a higher rate environment is the tech sector, especially early-stage cutting-edge tech companies. These companies tend to have high forecasted cash flows that are far into the future, the higher discount factors disproportionately impact these cash flows and so have a large impact in the share prices. However, QuantQuote notes that many major tech companies (such as Google, Microsoft, Apple, etc) despite being classified as technology companies have very high current cash flows and so are not impacted to the same degree as smaller tech companies. 

Interest rates have a direct impact on demand for real estate as most transactions in this sector require a significant amount of financing. Thus, real estate brokerages, home builders, and home ware vendors are all likely to suffer from reduced demand and price pressure. 

The final major sector to face headwinds is the utilities sector. These stocks are usually very stable and are able to pay steady dividends due to their consistent cash flows from long-term contracts. As such, they are a close proxy for bonds, so when interest rates are higher, investors will substitute bonds for utility stocks, reducing the demand and prices of the utility stocks.

In terms of the winners from a high-interest rate environment, finance stocks such as banks and insurance companies are usually the biggest beneficiaries. Higher rates is usually accompanied by a steeper yield curve and hence a wider gap between the shorter and longer dated rates. This gap results in a higher net interest margin for banks which is the largest driver of profits. Insurance companies will also benefit from higher yields on their bond investments, this can be a major boost to profits for insurance companies which are growing their asset base and hence able to invest fresh funds in the higher-yielding assets.