CIO Insights: The Value in a Fed Move

Recently, there has been increasing speculation among market prognosticators and investors alike about the U.S. Federal Reserve’s (Fed) intentions regarding interest rates. But we are not market prognosticators; we are disciplined, bottom-up value investors. We do not attempt to forecast the timing or magnitude of Fed actions but rather to identify undervalued securities that fit our fundamental process. That said, we believe it is likely the central bank will move sooner rather than later and that what the Fed does, and when, could have a swift and profound effect on U.S. stocks.

Read Davidson’s full Q3 2015 CIO InsightThe Value in a Fed Move

Energy Assumptions

Interest rates in the U.S. have been low—historically so—for several years. Accommodative policies enacted to stimulate the U.S. economy after the global Financial Crisis in 2008 have helped fuel a solid upswing in the domestic stock market while keeping normal levels of volatility at bay. Such conditions present challenges for our investment process.

As strict value investors, we seek to take advantage of mispriced securities and market inefficiencies that can be uncovered by our disciplined research and fundamental analysis. The unnaturally low levels of market volatility and interest rates that have supported U.S. stocks’ climb over the past six years or so have also combined to minimize the uncertainty that creates those market inefficiencies.

Accordingly, we think interest rates have to rise in the U.S. to help return stocks to healthy and normal levels of volatility. And when they do, we expect to see the change affect different sectors of the markets in different ways.

Potential Opportunities in Banks

Banks and other financial institutions have underperformed in the recent low-rate environment. Low rates have pressured margins and weighed on profitability. Anticipating a normalization of interest rates, we are therefore holding overweight positions in community banks, trust banks, and other rate-sensitive companies that we would expect to benefit as higher rates help to expand their net interest margins. How much and how often the Fed acts are questions that will lead to sorting out which particular opportunities in banking will prove to benefit most and move the most dramatically as rates rise.

Potential Downside Risk in Interest- Rate Sensitive Companies

On the opposite end of the spectrum, we have lessened exposure to traditionally interest-rate sensitive industries such as REITs (real estate investment trusts) and utilities. Utilities have benefited from years of historically low interest rates. Low rates have meant low borrowing costs and low financing rates for capital projects while keeping their dividends attractive to investors. A hike in rates by the Fed would be expected to reverse those trends and to tamp utility stocks’ prices, much like bonds. Similarly, after a prolonged period of appreciation amid near-zero rates, high-yielding investments such as REITs would likely see inverse price moves (i.e., declines) in response to any increase in rates.

Conclusion: Sticking to Our Process

We believe that sticking to our time-tested approach, regardless of the short-term effects of individual market factors, is critical to long-term outperformance. This is especially important during abrupt shifts in market conditions when active managers might be susceptible to attempting to capitalize on short-term market reactions.

The opinions expressed are those of Phillip N. Davidson, CFA, and are no guarantee of the future performance of any American Century Investments portfolio.

For educational use only. This information is not intended to serve as investment advice.