No one seems to know exactly when the Federal Reserve will raise interest rates. It could happen next week, maybe later this year or perhaps the central bank has, as some believe, missed its rate-hiking window altogether.
If the Fed does proceed with boosting interest rates, it makes sense for investors to be prepared. That task is made easier at the sector with exchange traded funds because, as has been widely documented, some sectors perform better than others against the backdrop of rising rates.
In a note out Friday, Bank of America Merrill Lynch examined the sectors that perform well after Fed liftoff, those that disappointed and those that were somewhere in the middle. Bank of America used the prior six tightening cycles beginning March 1983, January 1987, March 1988, February 1994, June 1999 and June 2004.
Below is a look at “which sectors performed best and worst going out one to 12 months following a Fed tightening cycle liftoff.”
Remembering that 1999 was the first full trading year for the nine sector SPDR ETFs (the funds debuted in late 1998), the examination yields some familiar trading ideas for how investors can profitably cope with rising rates.
Energy
Investors might be surprised to learn that the Energy Select Sector SPDR (ETF) XLE is a standout performer after interest rates rise.
“Energy was the top performing sector on average one month, three months and 12 months after the liftoff of a Fed tightening cycle and the second best performing sector six and nine months after liftoff,” according to the report.
Down almost 21 percent year-to-date, XLE is by far the worst performer among the nine sector SPDRs, but investors have added $1.62 billion to the largest energy ETF, good for the second-best inflows tally among the nine SPDRs. During the Fed's 2004 through 2006 tightening cycle, XLE climbed nearly 122 percent while the S&P 500 gained just 34.5 percent during that period.
“Energy did the best one to 12 months into a Fed tightening cycle and was ranked one or two during the 12 months after Fed liftoff, based on average cumulative price returns over these periods.
“The average rank for Energy over the 12 months was 1.3. Technology closely followed with an average monthly rank of 1.7 and was either the best or second best performing sector during the 12 months following Fed liftoff,” according to the report.
Technology
Like energy, technology is a cyclical sector, so the latter's durability against a backdrop of rising rates is not surprising because higher rates should signal the Fed's confidence in the sturdiness of the U.S. economy. Plus, the stockpiles of cash held by large U.S. tech firms are an advantage when rates rise.
“Technology companies hold a staggering 40 percent of the total corporate cash reserves in the United States [...] so they’re much less vulnerable to rising rates than debt-laden firms, such as utilities.
“Their strong cash positions mean they have the potential to continue on with their shareholder-friendly policies, such as share buybacks, dividend increases and M&A activity,” according to a recent iShares note.
However, the Technology SPDR (ETF) XLK lagged the S&P 500 during the last Fed tightening cycle, but XLK has historical data on its side. For months one through 12 after a Fed rate hike, technology is no worse than the second-best sector after energy, according to the data.
XLK In Focus
Remembering that cash is king when rates rise shines a light on XLK, because the ETF allocates a combined 25.4 percent of its weight to Apple Inc. AAPL and Microsoft Corporation MSFT. Those companies have roughly $300 billion in cash combined.
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