Rising Rates Are Coming -- Here's How To Prepare

If you racked up big gains in the stock market last year, you have Ben Bernanke and his cohorts at the Federal Reserve to thank.

The SP 500's 29.6% gain in 2013 (32.4% when dividends are included), which was the best year since 1997, was largely based on comments made by the Fed in December 2012.

Back then, the economy was so weak that the Fed committed to keep the federal funds rate at historic lows in place until at least the middle of 2015, even later than many economists had assumed. Against such a favorable interest rate backdrop, stocks faced little resistance.

Indeed, throughout 2013, the likelihood of an imminent increase in the federal funds rate remained off the table. And three Fed governors even suggested in December that interest rates would remain untouched into 2016.

But in the early months of 2014, the Fed playbook is starting to look different. The recently released minutes from the past Fed meeting in late January show that some Fed governors are getting anxious. As The Wall Street Journal noted recently, Fed governors have begun discussing "the possibility of rate hikes in the near future."

An increasing number of private economists agree. Just six months ago, none of the 79 economists polled by Bloomberg expected to see rates start rising within the next 12 months. Now, three of them do.

Most economists doubt rates will rise this year, but if the U.S. economy recovers from its recent flat spot, look for a growing number of economists to predict rates will start rising this year.

Why would the Fed move sooner rather than later? Recall that many Fed governors agreed that low rates needed to remain in place until the national unemployment rate fell to 6.5%. That figure hovered above 7% for most of 2013 but fell to 6.6% in January. We're coming up on the next monthly employment report, which could finally reach that 6.5% target.

The Fed won't act just because we reach that 6.5% figure, but if economists are correct that employers will boost hiring once the massive cold snap wanes, then we may start moving below 6.5%.

So how will stocks and bonds react to the end of this historic interest rate era? Probably in a mixed fashion.

To be sure, stocks can handle somewhat higher rates. Even if the federal funds rate returns to 3% or 4%, history suggests that the broader market can stand firm. Only rates higher than that would start to create a real drag, and that looks quite unlikely for the foreseeable future.

Then again, the key catalyst of stock prices will have been removed. That stunning gain for the SP 500 in 2013 will be impossible to repeat if the Fed starts to "take away the punch bowl."

Rising rates bring a silver lining to certain sectors. Industrial stocks need a backdrop of strong corporate confidence if they are to see an uptick in capital spending. Many companies have underinvested in PPE (plants, property and equipment) for the past half decade.

Back in November, I noted that Goldman Sachs economist Jan Hatzius expected "capital spending to strengthen (in 2014), with an added boost if consumption recovers in line with our forecast. This reinforces our view that private sector spending should accelerate in 2014, pushing GDP growth into the 3-3.5% range."

If he's correct, then investors should maintain a solid weighting in industrial stocks. The Industrial Select Sector SPDR ETF (NYSE: XLI) is a solid choice.

Investors should brace for further pressure on dividend-paying stocks. Real estate investment trusts (REITs), master limited partnerships (MLPs) and business development companies (BDCs) all experienced choppy trading when the 10-year rates started to rise last May, and an upward move in the federal funds rate will create further pressure. (That's why we've been shifting our attention away from absolute yields and toward investments that are capable of solid dividend growth.)

The fixed-income market will also respond to rising short-term rates. Many strategists think investors should trim exposure to long-duration bond funds, and stay focused on bonds that either have shorter duration or floating-rate structures.

Risks to Consider: Perhaps the biggest risk to the market in coming months would be a combination of rising rates and subpar economic growth. The Labor Department just noted that consumer prices rose 1.6% in January, the highest rate in six months. The Fed has always said it's comfortable with inflation at any level below 2%. The years of underinvestment in U.S. capital stock could eventually lead to inflationary capacity-utilization pressures. U.S. factories and power plants are currently 78.6% utilized, but a move up into the low 80s could trigger inflation alarms.

Action to Take -- The real concern for investors is that very few people are thinking about rate hikes starting later this year. Though just a handful of Fed governors and professional economists are talking about it right now, more vigorous economic data points could lead to more chatter around rate hikes. And since the market did so well in 2013 while rate hikes were off the table, investors can't be sure that the reverse won't be true in 2014. So keep a close eye on the economy in coming weeks and months. If the economic shows a springtime rebound, that may be all the reason you need to start locking in those great profits you made in 2013.

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