But while higher rates may pose a headache for some companies, new research from strategists at BMO Capital Markets shows there are more concerns about further rises in the S&P 500.
“Historical analysis of market performance shows that higher rates in themselves do not derail stock prices,” Brian Belsky, chief investment strategist at BMO, wrote in a note in mid-September. “Instead, we find that returns are slightly below average and, interestingly, slightly less volatile than at low interest rate levels.”
S&P 500 returns (dark blue) are softer when rates are higher, but much lower volatility means risk-adjusted returns (shown in the information ratio in orange) are higher. BMO Capital Markets
Higher interest rates have been correlated with lower market returns since 1979, although BMO also found that they led to lower volatility, as measured by the standard deviation of returns. After considering both returns and volatility by comparing information ratios, Belsky concluded that the risk-adjusted performance of the S&P 500 has actually been better when rates were higher.
“Our work shows that despite assumptions to the contrary, U.S. stocks can perform quite well in a high interest rate environment,” Belsky wrote.
US interest rates are set between 5.25% and 5.5%, the highest range since mid-2007. In fact, Belsky said, rates had been declining since the early 1980s with a few exceptions.
federal Reserve
After decades of inactivity, it’s not surprising that many investors have misconceptions about the impact of interest rates on stocks. Rate hikes are viewed as a threat because they reduce the present value of future corporate earnings, but low volatility mitigates that risk somewhat.
Furthermore, current market pricing suggests that rate hikes are almost over. The Federal Reserve may hike in November, but the market is almost certain it will leave the federal funds rate alone this week.
When rates rise, cash-flush companies in cyclical sectors come to the fore.
Higher rates generally don’t derail markets, Belsky wrote, and they are actually quite beneficial for companies with low debt and abundant free cash flow.
“One strategy that has generally produced favorable results is to focus on stocks with relatively low levels of leverage combined with high levels of free cash flow,” Belsky wrote. “This makes sense to us because higher rates should make operating conditions more challenging for stocks that have increased debt loads and weaker cash flow positions.”
BMO Capital Markets
According to BMO, stocks with that description stand to gain particularly in a higher rate environment if they belong to economically sensitive sectors.
“Rising interest rates are typically a sign of strong economic growth as the bond market readjusts levels to avoid inflation,” Belsky wrote.
Technology, energy and industrial companies have remained the backdrop of higher rates since 1991, while defensive sectors have lagged behind, Belsky wrote. This finding contradicts the conventional wisdom that techs suffer when rates rise because their high earnings multiples get compressed. In fact, tech lagged in 2022 but has been the top sector this year.
BMO Capital Markets
28 Stocks That Will Benefit from Higher Rates as Stocks Rally
The consensus on Wall Street in 2023 has been that as long as interest rates are an issue, the upside for US stocks is limited. BMO wasn’t entirely in that camp, although it had entered the year with skepticism about the economy. Also in May, Belsky and his team said the S&P 500 had limited upside.
But a few months later, BMO once again became one of the most bullish investing firms by raising its year-end S&P 500 target to 4,550. And if all goes well in the market, new all-time highs cannot be ruled out by the end of the year. Such a move would shatter all expectations from the end of 2022.
Investors can continue this market rally by targeting stocks with limited leverage and abundant free cash flow as interest rates are still high.
Below are 28 companies that are in the top 25% of BMO’s leverage and cash flow multi-factor models and have outperform ratings from the firm. Each is accompanied by its own ticker, market capitalization and region.
Source: www.businessinsider.com
