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Why a Fed Rate Hike May Catch Investors Off-Guard

MarketMarket
Traders working on the floor of the New York Stock Exchange.Photograph by Andrew Burton — Getty Images

Investors may have a case of being in the wrong place at the wrong time.

Thursday offered evidence of that. The stock market was down over 200 points. The reason for the sell off seemed to be a number of speeches by Fed officials, including NY Fed head William Dudley, that indicated that the U.S. central bank was likely to go ahead with a rate hike in December.

Some strategists have argued that even if the Fed does raise rates, investors don’t need to freak out. It would be a sign that the Fed thinks the economy will continue to improve, which should be good for corporate profits and the market. Stocks have continued to rise in other Fed tightening cycles.

Nonetheless, it appears that if a rate hike does happen, many investors may end up being caught off-guard. And that’s what could be causing the freak out.

At least that appears to be the case according to the analysis of Ian Scott, a market strategist at Barclay’s in London. On Thursday, Scott published a report that looked at the sectors of the market that fare best and worst when the Fed raises rates. According to Scott, value stocks generally do better than growth stocks. Other sectors that could do well are financial stocks, which could benefit from higher interest rates; and industrials and commodities, since a interest rate hike would suggest the economy is doing better.

Sectors that haven’t tended to do well are health care, utilities and telecom stocks.

Here’s the problem: Investors haven’t been buying in the sectors that Scott thinks will do well. Value stocks, for instance, have in general fallen 2.3% since the middle of the year. That’s a bigger drop than the S&P 500 over the same period, which is close to break over that time frame. Bank stocks have also performed worse than the market, down 1.7% since the middle of this year. And media stocks–another sector that Scott says does relatively well when interest rate rise–have fallen 2.4% since the middle of this year.

On the flip side, a number of sectors that tend to perform poorly when interest rates rise appear to be where investors have been putting their money in the past few months. The price of utilities stocks, for instance, are up 2.4% since the middle of this year.

The caveat is that not every cycle plays out the same. Just because some sectors did well the last time the Fed increased interest rates doesn’t mean they’ll do well this time. And investors might be anticipating that. Scott points to energy stocks as a prime example that investors are not ready for the Fed rate tightening cycle. Energy stocks have tended to do well when interest rates rise, and Scott thinks investors should therefore be buying in. Yet this year, investors have generally avoided energy stocks, which have been among the market’s worst performers. But this time around, that might turn out to be the right call. Oversupply of oil and slowdown in China may mean that shares of energy companies could continue to suffer, despite what happened in past rate hiking cycles.

It is likely that different stocks will lead the market after the Fed decides to raise rates than have in the past few years. And indeed, the market does tend to get a little rocky when the tightening begins. But based on where investors appear to have put their money in the past few months, it could be rockier than before.