Friday, November 22, 2013

How Rising Rates Affect the Economy

 
Money and Markets
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How Rising Rates Affect the Economy
by Mike Larson

Dear Friend,

xxxxx

Many investors think in black and white terms when it comes to the impact of rising interest rates on the economy and the stock market.

The truth is, rising rates can be extremely bearish for some sectors and bullish (or at least neutral) for others.

Let's start with the problems of rising rates. I can't think of a sector that's more vulnerable than housing. Rising rates make mortgages less affordable for traditional home buyers. They also drive away many of the "Echo Bubble" real estate investors we've seen pour into the market in the past year and a half.

REITs are another problematic sector — and so are utilities. They are typically seen as "bond proxies" among investors due to their high dividend yields. As overall interest rates go up, those high yields become less attractive — and many investors take their money and run. That's why REITs have been such lousy performers in 2013, and why I wouldn't touch them with a ten-foot pole in 2014 either.

In the financial sector, it's more nuanced. Banks with large amounts of mortgage exposure will see revenue squeezed by rising interest rates (and the slowdown in loan-making that results). But some plain-vanilla banks might actually benefit from the increased spread, or difference, between the yields they pay out on deposits and the yields they can earn from longer term loans or securities.

As for winners, it all comes down to what's driving yields higher. If one of the reasons yields are rising is that the economy is getting better, then sectors like aerospace, cyclicals, domestic energy producers, and more can actually prosper. You may be able to find some investible names within those sectors.

So where do we stand now? Well, we saw the first phase of interest rate-driven chaos this spring and summer. Rate-sensitive stocks got hammered, and bond prices plunged, when the Fed began to lose control of the markets amid newfound "taper talk." We had a temporary reprieve in September and October, but once again, the bond market is flexing its muscle and selling off.

So that makes those rate-sensitive sectors losers in my book ... even as I continue to advocate investing in some of the sectors that have little to no rate exposure.

But a word of caution: Eventually interest rates will rise so far, so fast, and for so long that the entire economy won't be able to handle it anymore. That's when you'll want to unload virtually all of your equity exposure in order to avoid massive losses. So whatever you do, don't lose sight of what the interest rate market is doing — it is the sun around which all the other markets ... and the economy ... revolve!

Best wishes,

Mike

P.S. All week this week my colleagues and I have been joining readers on the Money and Markets blog to discuss current events and our forecasts for 2014 in preparation for our special year-end conference.

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