By Jeff Reeves
One of the biggest stories investors are watching is how the Federal Reserve will act to alter interest rates.
Unemployment is low, inflation is high, and a Fed economic projection released at the end of last year suggests benchmark rates might sit at 2.1% by the end of 2024.
To be clear, this isn’t the 10-year Treasury bond /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +0.24% rate — this is the fed funds rate, which currently is a rock-bottom range of zero to 0.25%. So if the key foundational rate is 2.1%, just imagine where corporate bonds, mortgages and credit card rates will be.
Of course, rising rates should never be seen as a death knell for the economy. For those who remember, the current rate environment was achieved in large part because of crisis-era cuts back in 2008 and 2009. If we do see a 2.1% fed funds rate, many may actually see it as a sign that America is on the right track again.
It’s an open question how fast we’ll get there, however, or if we’ll get there at all. A resurgent Covid-19 pandemic and labor market issues are just two of the most obvious challenges to a thriving U.S. economy. Still, given recent movement in rates, it’s worth considering how to reposition your portfolio to protect yourself if and when this shift happens.
Here are five related trades to consider.
Buy bank stocks
Already, 2022 is shaping up to be a tremendous year for financial stocks as many big names in the sector have started the New Year with their best performance in more than a decade.
Across the first five trading days of the year last week, Citigroup /zigman2/quotes/207741460/composite C +0.93% surged 9% and Bank of America /zigman2/quotes/200894270/composite BAC -1.23% jumped 10%. Mid-sized banks including Regions Financial /zigman2/quotes/202396577/composite RF +0.45% and M&T Bank /zigman2/quotes/207957637/composite MTB -1.70% did even better, and were up about 15%.
There’s no complicated reason as to why financial firms are a good play in a rising interest-rate environment. Simply put, they increase the rates they charge for loans they extend to others and their margin on lending improves.
The icing on the cake is that many of these firms have borrowed capital from Wall Street via major bond offerings at a lower rate based on market conditions in prior years. Take Bank of America, which used a favorable environment to lock in a $3.25 billion bond sale in October at only 1 percentage point above Treasuries at the time.
There are many ways to play this trend, either through individual stocks or ETFs. But one of the most straightforward methods is to play smaller, regional banks that are very much lenders rather than complex global financial players. The SPDR S&P Regional Banking ETF /zigman2/quotes/200108291/composite KRE -1.21% is a great option if this strategy appeals to you, as it is well-established with $6 billion in assets and diversified across 140 small and mid-sized players including Regions and M&T. And unlike some market-cap weighted funds, no single position is worth more than 2% or so of the portfolio at present, as it regularly rebalances to spread your cash around these holdings.
KRE is up 9% year-to-date, thanks in part to the anticipation of rising rates, and could continue to outperform if this trend persists.
Tread lightly in tech
There are plenty of big-picture concerns for tech stocks, whether it’s the copious brand tarnish in the sector or recent anti-trust movements around the globe. But one more material concern for tech stocks large and small should be the rising rate environment and its affect on their books.
Almost all major tech companies are characterized by a premium share price today based on the potential of future profits. However, rising rates naturally mean future profits are worth less today than they once were — and Wall Street is less eager to pay nosebleed valuations based on where a company will theoretically be in a year or two.
Furthermore, rising rates are in many ways a good sign for the broader economy as it means businesses and consumers across the board are doing better and can support this shift. That means less motivation for investors to plow their cash into start-ups disrupting old business models and more motivation to look at traditional value plays that may not have a unique value proposition other than simply riding rising global demand. This is particularly true for large and mature companies deep in their life cycles.
Consider that while the S&P 500 /zigman2/quotes/210599714/realtime SPX -0.58% is up about 5% in the past three months or so, trillion-dollar tech darlings Meta Platforms /zigman2/quotes/205064656/composite FB -0.49% and Amazon.com /zigman2/quotes/210331248/composite AMZN +0.19% are both down about 4%. Meanwhile, top performers in the S&P 500 over the same period include discount retailer Dollar Tree /zigman2/quotes/203712248/composite DLTR +1.32% and legacy automaker Ford /zigman2/quotes/208911460/composite F +0.55% .