Which US equities benefit from rising interest rates?

While the causes of this are many and complex, the result has been the same across developed markets with central banks raising interest rates in an effort to prevent the price rises becoming a longer-term feature of the economy.

In the US, rates have risen further and faster than in the UK, and the Federal Reserve has raised the base rate by 0.75 percentage points at three consecutive meetings, with markets pricing in another similar rise in early November.

Key for investors is being aware that rising interest rates mean future cash flows are given a lower value by the market today – this hits almost all companies but has a particularly acute impact on companies such as start-ups, which may not have strong cash flows for many years. 

Loan growth, at least so far, remains healthy.Eric Papesh, T Rowe Price

Although expected earnings for the S&P 500 have increased from $223 (£193) at the start of the year to roughly $235 currently, interest rates have hampered the overall outlook, says Eric Papesh, portfolio specialist for US equities at T Rowe Price.

“Interest rates have increased meaningfully and as a result, we’ve seen the price-to-earnings multiple contract from 21 times to 16 times today,” he says.

Ron Temple, head of US equity at Lazard Asset Management, says he is increasingly optimistic that now is a time when investors should be thinking about what to buy, as opposed to what to sell.

"[Investors] should be thinking about what high-quality companies to buy now that in two to three years they will be very happy to have purchased," he says.

While it is harder to quantify, rising rates increase the cost of financing for the big-ticket consumer items such as cars, and housing, reducing demand for them, Papesh says.

“On the positive side, higher rates are typically associated with better levels of profitability for banks and insurance companies, depending on which rates are increasing and the overall steepness of the yield curve."

We are definitely in an era of less liquidity, but it is not disastrous by any means.Rupert Rucker, Schroders

The financial sector is always touted as being a beneficiary of high interest rates, as they charge higher rates on loans without having to pay their depositors as high a rate.

Papesh says he is seeing strong growth in net interest income in US banks on the back of these higher rates, and capital ratios have improved “dramatically” over the past decade.

“Loan growth, at least so far, remains healthy,” he notes.

However, when investing in banks, it is important to watch credit conditions, warns David Harrison, manager of the Rathbones Greenbank Global Sustainability Fund.

“At the moment they are OK in the US, the job market is strong, and [households are] still running down some of the Covid savings, but I think [investors should] keep a close eye on next year.”

Tech changes?

Large US technology companies have been among the most sharply sold off assets in 2022 so far.

Despite this repricing, the sector remains one of the most expensive when looking at traditional valuation metrics, though there are some opportunities, Papesh says.

“There are some specific companies we think have wrongly been caught up with the broader sell-off within the tech space – Qualcomm for example – but at the broader sector level, multiples are still high versus the rest of the market and the cash flows of many of these businesses are going to slow along with the rest of the economy.”

The small cap end of the market is looking attractive, Papesh says, as they are trading at historically low valuations compared to large cap competitors, reflecting investors’ concerns of a looming recession.

A US small cap is a large cap in Europe.Rupert Rucker, Schroders

But earnings are still holding up and are likely to improve once the economic outlook stabilises, he adds.

“Coming out of past market downturns, smaller cap companies have typically led the recovery… the move from the lows typically occurs quickly, and it’s important that investors have exposure to the space at the inflection point.”

It is worth remembering that companies that fall into the small and mid cap buckets in the US are much bigger than their counterparts in the UK.

Mid-cap can be anywhere from $250mn to $48bn, says Rupert Rucker, global investment director at Schroders.

“A US small cap is a large cap in Europe.”

The lower valuations of small-cap companies mean that when accounting for the future impact of a higher cost of capital they look much more reasonably priced than large caps. 

“Everything has been valued sensibly for years, such that if you get surprises you will not see huge reactions to share prices,” Rucker says.

A few themes to look into are healthcare and domestic manufacturing, he adds.

“Home health care is a growing sector, it has suffered a labour shortage but that is beginning to mitigate,” he says.

There will still be lots of investment made, and better returns.Rupert Rucker, Schroders

Ben Kumar, senior investment strategist at 7IM, agrees that healthcare is the sector society will continue to focus on, and will see long-term growth as a result.

“In a recession, you are going to cut back your spending on lattes and iPhones, but you will still pay for your medication and you will still go to hospital if you need to, and all of that finds its way to the bottom line.”

The manufacturing sector in the US is also one to watch, benefitting recently from several big parts of legislation, including the infrastructure bill, the Chips and Science Act and the Inflation Reduction Act.

“This top down, multi-year support for this sector [has not existed] in the past… and this benefits small and mid-caps given their domestic exposure,” Rucker says.

The relative size of small and large caps also means they are not impacted by a withdrawal in cheap money driven by rising interest rates, as can happen in the UK.

“We are definitely in an era of less liquidity, but it is not disastrous by any means. 

“There will still be lots of investment made, and better returns.”

sally.hickey@ft.com