Interest Rates and Their Effect on Everything

05/18/2016 9:26 am EST

Focus: STOCKS

Michael Berger

President & Founder, Technical420.com

Although economic data reported yesterday showed improvements, the market sold off as the probability of an interest rate hike increased and Michael Berger the Associate Editor of MoneyShow.com, discusses which industry may benefit from higher rates.

The stock market sold off yesterday even though oil prices continued to move higher and favorable economic data was reported.

Yesterday, the Commerce Department reported that housing starts during April increased more than expected as builders ramped up the construction of single and multi-family homes. This report, coupled with a strong April retail sales report, supports the view that the economy has been regaining steam early in the second quarter.

The Labor Department also released data showing that the cost of living increased in April by the most significant amount since 2013. During April, the Consumer Price Index increased by 0.4%, higher than the 0.3% forecast. Based on this report, inflation may be picking up toward the Federal Reserve’s goal.

Two Fed Reserve Officials Create Fear

The reason for yesterday’s weakness is simple; favorable economic data has increased the chances of multiple interest rate increases during 2016. Another factor contributing to yesterday’s weakness stems from the comments made by Atlanta Fed President Dennis Lockhart and San Francisco Fed President John Williams.

The two Federal Reserve officials said that the central bank could raise interest rates as soon as June and that the decision depends on the data (which has been positive). Williams agrees with Lockhart who has said that there could still be two or three rate increases this year and commented that there was only a narrow range of differences within the FOMC committee.

In a separate meeting, Dallas Fed President Robert Kaplan said the central bank should raise rates in the not-too-distant future.

Best Course of Action for Investors

So now the question is how can investors protect and preserve their investments if the Fed raises rates in June?

Gold has been the greatest beneficiary of the slower approach to interest-rate increases and the precious metal is up 20% this year. If the Fed increases rates, this will serve as a headwind for both metals and mining stocks. Funds like SPDR Gold Shares (GLD), Direxion Daily Gold Miners Bull 3X ETF (NUGT), and VanEck Vectors Gold Miners ETF (GDX) are already starting to decline.

Multi-national corporations with significant international exposure like Apple (AAPL), Proctor & Gamble (PG), and Coca-Cola (KO) will also be impacted by higher interest rates because it will strengthen the dollar, it will make exports more expensive and will thus impact profits.

If the low oil price environment has not affected energy companies and master limited partnerships (MLPs) enough already, then higher rates certainly will.

Real estate investment trusts (REITs) are highly sensitive to interest rates and higher rates would serve as a headwind for the sector.

Are Banks the Best Bet?

Banks would be the greatest beneficiary of higher interest rates due to their ability to lend money at higher rates. The financial sector has been under heavy pressure this year as the probability of an interest rate hike (or two) seemed unlikely during the first quarter.

The Financial Select Sector SPDR ETF (XLF) has rallied off of its 2016 lows, as the index fell more than 18% during the first six weeks of the year. XLF is up 9% during the last three months and the index is down 4% during 2016.

Selectivity is Key with Financial Stocks

Although banks are poised to benefit from higher rates, investors must be selective. Spillover risk represents one of the greatest risks faced by the economy and is what banks and lenders face on account of the weak oil price environment.

Low oil prices have already had a negative impact on banks highly exposed to the energy sector and this is a trend that we expect to continue.

Although oil prices have soared more than 70% off of their 2016 lows, it has done little to improve the prospects of overstretched borrowers which has increased the possibility of defaults and bankruptcies for companies and their lenders in the months ahead.

Earlier this year, several of the largest domestic banks like Citigroup, Inc. (C), Wells Fargo & Company (WFC) and JPMorgan Chase & Co. (JPM), warned about the ripple effects caused by weak oil prices.

Many analysts have said that a bank’s energy exposure would likely weigh on earnings throughout the year and in some cases offset improvements in credit quality in other parts of their loan portfolios.

Regional Banks More at Risk

Banks have started to reset borrowing limits for its energy clients, which are even lower than the cuts made during the same period last year.

Although banks like Wells Fargo, JPMorgan, and Citigroup are setting aside hundreds of millions of dollars for potential loan losses, the risks are not as great because their energy portfolios make up a small portion of their respective balance sheets.

Regional banks are more at risk because they tend to have a much higher energy loan composition. For example, BOK Financial Corporation (BOKF), Cullen/Frost Bankers, Inc. (CFR), and Texas Capital Bancshares, Inc. (TCBI) have a 19.4%, 15.3% and 10.2% energy loan composition, respectively.

Five Favorite Banks Stocks

We continue to see value in owning the smaller acquirers that are not heavily levered to the energy sector. Investors should continue to own banks that are seasoned acquirers and can use their currency advantage to drive EPS growth. Also, look for banks that offer a differentiated product or are focused on a niche sector that can grow faster than the industry.

We expect to see small- to mid-cap banks outperform the banking industry due to lower regulatory costs, leverage to rate increases, and fewer revenue headwinds. Larger regional banks will face upward pressure on regulatory and technology costs as well as revenue headwinds due to the inability to improve profitability without higher rates.

So the real question many investors are asking themselves is, which banks are most likely to benefit from rising interest rates? The companies we expect to benefit the most are Meta Financial Group, Inc. (CASH), Wintrust Financial (WTFC), SVB Financial (SIVB), Bank of the Ozarks, Inc. (OZRK), and BofI Holding, Inc. (BOFI).

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