NEWS ALERT March 16, 2022, 4:20 p.m. EST: On Wednesday, the Federal Open Market Committee announced it would raise the target federal funds rate 25 basis points (0.25%) to slow decades-high inflation.

Interest rates rise and fall as the economy moves through periods of growth and stagnation. The Federal Reserve is an important driver for rates, as Fed officials often lower rates when economic growth slows and then raise rates to cool the economy when inflation becomes a concern.

Increasing rates require careful attention when crafting an investment portfolio. For example, one approach might be to bolster positions in short-term and medium-term bonds (which are less sensitive to climbing rates) or implement a “bond ladder” to maximize cash and debt returns.

But an environment where interest rates are rising amid signs of an improving economy can also offer opportunities for investors within the equity space. A good starting point is examining the sectors within the stock market that tend to benefit from higher rates.

Financials First

The financial sector has historically been among the most sensitive to changes in interest rates. With profit margins that actually expand as rates climb, entities like banks, insurance companies, brokerage firms, and money managers generally benefit from higher interest rates.

Rising rates tend to point to a strong economy. And that health usually means that borrowers have an easier time making loan payments and banks have fewer non-performing assets. It also means that banks can earn more from the spread between what they pay (to savers for savings accounts and certificates of deposit) and what they can earn (from highly-rated debt like Treasuries).

Banks that might benefit as rates rise include Bank of America Corp. (BAC), which has a substantial presence throughout the U.S.; JPMorgan Chase & Co. (JPM), with its robust operations in the U.S. and worldwide; Goldman Sachs Group Inc. (GS), with widespread investment banking and wealth management services, and Citigroup Inc. (C), which does business in more than 160 countries. 

On the broker front, companies like E*TRADE Financial Corp., Charles Schwab Corp. (SCHW), and TD Ameritrade Holding Corp., all hold promise during times of escalating rates for similar reasons. A healthy economy sees more investment activity and brokerage firms also benefit from increased interest income when rates move higher.

Insurance stocks can flourish as rates rise. In fact, the relationship between interest rates and insurance companies is linear, meaning the higher the rate, the greater the growth. These same insurance providers, such as The Allstate Corp. (ALL), AmTrust Financial Services, Inc. (AFSIN), and The Travelers Companies, Inc. (TRV), don’t fare as well in low-rate climates because their underlying bond investments yield weak returns.

Insurers, which have steady cash flows, are compelled to hold lots of safe debt to back the insurance policies they write. In addition, the economic health dividend also applies to insurers. Improving consumer sentiment means more car purchasing and improving home sales, which means more policy-writing.

Beyond Financials

Financials aren’t the only star performers in a rising rate environment. Consumer discretionary stocks also can see a bump because improving employment, coupled with a healthier housing market, makes consumers more likely to splurge on purchases outside of the realm of consumer staples (food, beverages, and hygiene goods).

Manufacturers and sellers of kitchen appliances, cars, clothes, hotels, restaurants, and movies also benefit from the economic health dividend. Companies to keep an eye on during interest rate increases include appliance maker Whirlpool Corp., and retailers Kohl’s Corp., Costco Wholesale Corp., and Home Depot, Inc. 

Finally, the industrials sector also benefits from the economic health dividend indicated by rising rates. Companies like Ingersoll-Rand PLC and manufacturers of heating, ventilation, and air conditioning (HVAC) systems, tend to outperform, as well as companies like PACCAR, a maker of heavy-duty trucks and truck parts. Such companies are among the first to benefit from any increase in housing starts.

The Bottom Line

You’ve adjusted your fixed-income portfolio to account for rising rates. Now is the time to adjust your equity investments to favor companies that benefit from the economic health dividend indicated by rising rates. Again, an excellent place to start is the financial sector. From there, as consumer confidence picks up and housing follows suit, consider manufacturers of durable goods, retailers, travel-related stocks, and the industrials sector.