The Federal Reserve is about to raise interest rates several times. That means it’s time for technology, classically defensive and quality stocks to shine.
Inflation is the worst since the early 1980s and is just slightly below what would likely have been the peak, so the Fed is expected to raise short-term interest rates at least four times this year . This could help lower long-term bond yields, as higher short-term rates are designed to dampen economic demand, lowering the longer-term rate of inflation. Inflation expectations pushed long-term yields higher.
This makes a big difference for technology stocks. If long-term bond yields slowly rise or even fall, that would be good for tech valuations, as lower yields increase the discounted present value of future earnings. Many tech companies are valued based on the earnings they are expected to generate years from now, rather than what they are generating now.
Indeed, 12 months after the first rate hike in a new cycle of hikes,
Tech stocks have outperformed the broader index by 13 percentage points, on average, since 1994, Evercore data shows.
The same could apply to tech stocks today. The tech-heavy Nasdaq is already down 13% from its all-time high on Nov. 19 as the 10-year Treasury yield soared. It might be time to buy the dip, although there may be more pain in the short term.
Classically defensive stocks — those of companies selling goods and services that remain in high demand even when consumers and businesses have less money to spend — are also generally good bets when the Fed starts raising rates. S&P 500 utilities, real estate and healthcare stocks have outperformed the broader index by 4, 7 and 2 percentage points, respectively, in the 12 months following an initial rate hike since 1994, on average.
Quality stocks, regardless of sector, are another area to focus on. These companies have stable cash flows, either because they are in defensive sectors or because they are well established and very competitive. They typically have large balance sheets with minimal debt.
Companies with a light debt burden often do not see a significant spike in the interest rate on their existing bonds when rates rise, allowing their valuations to remain relatively high. Quality stocks in the S&P 500 have historically outperformed the broader index by 3 percentage points during the year after an initial rate hike.
“Tighter financial conditions are a tailwind to earnings quality,” wrote Dennis DeBusschere, founder of 22VResearch. You just need to buy those stocks before investors bid their prices higher.