How higher interest rates will affect investors


May 02, 2004|By EILEEN AMBROSE

IT HAS BEEN years since investors worried about rising interest rates.

After a series of rate cuts by the Federal Reserve to pull the economy out of a 2001 recession and shake off its remnants, investors have grown accustomed to the lowest rates in decades.

That's about to change. In a recent update to Congress, Fed Chairman Alan Greenspan said a key short-term interest rate under Fed control would have to be raised at some point to stave off inflation.

"They are heading higher. The issue is how much and over what period of time," said Samuel A. Lieber, president of Alpine Mutual Funds in Purchase, N.Y.

Many factors can influence the timing and degree of Fed action, but experts are confident that there won't be a repeat of what happened in 1994, when the Fed began raising rates after another period of low rates coming off a recession.

"The Fed has learned a lesson. Back in '94, the Fed put rates up too high. They stole the economy," Lieber said.

In a period of a year, the Fed doubled the federal funds rate to 6 percent. Stocks went through many choppy months and ended the year pretty much flat, Lieber said. Bond prices got hammered.

This time, many expect the Fed to make its move in August by raising the federal funds rate - the rate banks charge each other for overnight loans - a modest quarter-point to 1.25 percent. By this time next year, the rate might be 1.75 percent to 2.5 percent, which is still low, experts said.

This rate influences the prime rate, the benchmark for consumer and business borrowing.

So, what can investors expect in this environment?

The obvious winners will be risk-averse savers and retirees whose interest income from money market funds, certificates of deposit and other bank accounts has dwindled in recent years. A one-year CD paid an average of 1.19 percent last year, compared with 5.67 percent nearly four years ago, said Greg McBride, a senior financial analyst with in Florida.

He predicts that a year from now, one-year CDs will average 2.5 percent to 3 percent, with higher rates coming later.

The stock market overall should make gains, although shares in companies sensitive to interest rate increases will lag, experts said.

"The equities market in the past generally has flourished in the early stages of an interest rate rising cycle," said William Hummer, chief economist with the brokerage Wayne Hummer Investments in Chicago. At this stage, the economic growth is evident; companies can raise prices without inflation being a problem; and the stock market is cheered, he said.

This is the stage we're at now, he said. "It's a benign time. Enjoy it while we can."

Investors should be looking for companies whose products will be in demand here and abroad as the economy rebounds.

"Focus on stocks that will respond to economic growth - the industrial sector, tech sector," said David L. Straus, a senior portfolio manager with Johnston Lemon Asset Management in Washington. "They will be able to grow as rates creep up."

Some expect energy stocks to do well. "Consumption will rise," Hummer said.

Health care companies also tend to be immune to rate increases and get the added demographic benefit of an aging population that will need more drugs and medical care, experts said.

"Look international. Look beyond the U.S. marketplace," suggested Christopher Sheldon, director of investment strategy for Mellon's private wealth management group in Boston. "We believe this is a global expansion and global recovery, especially in emerging markets."

Specifically, look to Asia and Latin America, whose recoveries are slightly trailing that of the United States and, therefore, whose stocks still offer good value, Sheldon said.

Industries that tend to be negatively affected by rising rates include housing, utilities and financial services, particularly banks with a heavy concentration in mortgages. Financial stocks have taken a drubbing. Some say that's an overreaction.

"Ever since all this hysteria over increasing interest rates raised its head here lately, financial [companies] got hammered," said Margaret Jones, chief executive of Whittlinger Capital Management in Minneapolis. Investors can take advantage of this by snapping up good companies whose prices have been beaten down, she said.

"Once people realize the Fed will not do that much damage, you'll see [these stocks] improve and can capture some market overreaction," she said.

Utilities and real estate investment trusts are likely to see demand for their shares decline as rates rise, experts said. Investors swarm to these securities when rates are low because they offer high dividends. But as rates rise, income-seeking investors have more alternatives.

For bond owners, rising rates don't help. That's because new bonds will offer the higher rates, and investors wanting to sell their older bonds will have to do so at a discount to attract buyers.

"Generally speaking, in a rising rate environment, you want to buy shorter-term securities. They are less sensitive, and don't adjust as much as long-term securities," said Mary J. Miller, director of fixed income at T. Rowe Price Associates in Baltimore. "That being said, we are a bit cautious on short- and intermediate-term securities."

One strategy is to park cash in money market funds and shift into bonds after rates climb, she said. "If you can be patient, that might be a good place to wait it out a bit," Miller said.

Miller also likes international bonds. "In many cases, interest rates are higher in Europe and other parts of the world than the United States," she said. Additionally, "they lag us in terms of growth, so they may be behind us in interest rate rising."

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at

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