Minutes from the U.S. Federal Reserve’s September meeting confirmed that the central bank is most likely to continue hiking benchmark lending rates at a gradual pace this year and beyond.
Rising interest rates are bad news for most stocks as it raises borrowing costs and squeezes profit margin. On the other hand, banks and other financial stocks see a bump up in profits on steady interest rate hikes. Thus, investing in such stocks for now seems judicious.
Fed Minutes: Further Rate Hikes ‘Most Likely’ Needed
United States central bankers found no reason to halt their current course of gradual interest rate hikes, per the minutes of the Federal Open Market Committee’s (FOMC) Sep 25-26 meeting minutes released on Oct 17.
Majority of the Fed policymakers said that rate hikes “would most likely be consistent” with economic expansion, strength in labor market and the current period of firming inflation. They say that to avoid creating asset bubbles or inflation above the Fed’s desired target of 2% for too long, the central bank needs to raise rates.
The sense of the meeting was more hawkish than analysts might have thought. At the same time, the minutes showed that policymakers were largely in agreement about steady increase in benchmark lending rates even though it has irked President Trump.
Fed Expects to Raise Rates Again in December
The Fed has signaled another hike in December and three more next year. The Fed’s so-called “dot plot” currently show that 12 officials predict another quarter-point rate hike in December, up from eight officials in June. Looking at next year, four Fed officials expect two rate hikes, four officials anticipate three and four officials see four hikes. And for 2020, almost all officials predict one more rate hike.
Policymakers under Chairman Jerome Powell, by the way, have unanimously hiked rate by 25 basis points to 2-2.25% last month for the third time this year. Rates are now at the highest levels since October 2008, just after the collapse of Lehman Brothers.
Winners in a Rising Rate Environment
Now, which areas are set to make the most of a rate hike? Of course, financials! Banks are definitely the go-to rate trade now. As a rule, higher interest rates boost bank profits as they increase the spread between what banks earn by funding longer-term assets, such as loans, with shorter-term liabilities.
National banks like the Bank of America Corporation (BAC - Free Report) are very rate-sensitive and have consistently seen earnings rise on a quarter-point rate hike.
Very few companies root for a rate hike as much as those in the insurance industry. This is because the relationship between interest rates and insurance companies is linear and straightforward, meaning the higher the rate, the greater the growth.
Insurers derive their investment income from investing premiums, which are received from policyholders in corporate and government bonds. Yields and coupons on these bonds rise in response to a rise in Fed fund rates and bank interest rates. This enables life insurers to invest premiums at higher yields and earn more investment income, expanding their profit margins.
Not only investment income, which is an important component of insurers’ top line, annuity sales should benefit from a higher rate environment.
Brokerage firms advantage significantly from an increasing rate environment since a hike in rates generally occurs during periods of economic strength and upbeat investor sentiments.
Notably, a wealth management firm like The Charles Schwab Corporation (SCHW - Free Report) has said time and again that each quarter point increase in rates generally adds to interest revenues, much of which flows directly to pre-tax profits.
Top 5 Picks
Given the aforesaid positives, we have selected five solid stocks from these winning areas that boast a Zacks Rank #1 (Strong Buy) or 2 (Buy).
First Bancorp (FBNC - Free Report) provides banking products and services for individuals and small to medium-sized businesses, primarily in North Carolina and Northeastern South Carolina. The company currently has a Zacks Rank #2. The Zacks Consensus Estimate for the company’s earnings rose 1.3% in the last 60 days. The company’s expected earnings growth rate for the current year is 63.2% compared with the Banks - Southeast industry’s estimated rally of 31.3%.
First Mid-Illinois Bancshares, Inc. (FMBH - Free Report) provides community banking products and services to commercial, retail, and agricultural customers in the United States. The company currently has a Zacks Rank #2. The Zacks Consensus Estimate for the company’s earnings rose 0.7% in the last 60 days. The company’s expected earnings growth rate for the current year is 25.5% compared with the Banks - Northeast industry’s projected rise of 21.7%.
Horizon Bancorp, Inc. (HBNC - Free Report) provides commercial and retail banking services. The company currently has a Zacks Rank #2. The Zacks Consensus Estimate for the company’s earnings rose 0.7% in the last 60 days. The company’s expected earnings growth rate for the current year is 44.1% compared with the Banks - Northeast industry’s estimated rally of 21.9%.
Berkshire Hathaway Inc. (BRK.B - Free Report) provides property and casualty insurance and reinsurance. The company currently has a Zacks Rank #1. The Zacks Consensus Estimate for the company’s earnings rose 8.8% in the last 60 days. The company’s expected earnings growth rate for the current year is 68.9% compared with the Insurance - Property and Casualty industry’s estimated rally of 26%.
Ameriprise Financial, Inc. (AMP - Free Report) provides various financial products and services to individual and institutional clients in the United States and internationally. The company currently has a Zacks Rank #2. The Zacks Consensus Estimate for the company’s earnings rose 0.3% in the last 60 days. The company’s expected earnings growth rate for the current year is 20.1% compared with the Financial - Investment Management industry’s projected rally of 5%.
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