In recent weeks, the likelihood of a Federal Reserve interest rate hike has been increasing. I recently pointed out a few reason on why I believe the Fed will increase rates at the upcoming December meeting, which you can read here. I also have pointed out a few industries that would benefit from a rate hike and which corresponding ETFs that could benefit from such a move by the Fed.
So, today let's take a look at a few industries that will likely suffer from an interest rate increase and which ETFs you may want to avoid if the Fed makes a move.
Oil and Gas
As a whole, the Oil and Gas Industry is not doomed when an interest rate hike comes, but those companies who have large amounts of debt on their balance sheets will have a first-class ticket to the pain train. The majority of the companies in the oil and gas industry who have large amounts of debt are the smaller exploration and production companies. Over the past few years, these firms spent millions buying mineral rights from property owners in the hope they would find large deposits of oil and gas underneath the ground. The big rush to buy rights came because of improved fracking technology which now makes it possible to extract fossil fuels from shale formations deep underground. The cost of the lease rights combined with the cost of drilling have added up for most of these companies and only compounded with low oil and gas prices. Refinances this debt down the road at what most certainly will be a higher rate, if the Fed makes a move, will not be good.
The three none leveraged ETFs that focus on the oil and gas exploration and production companies are, the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), iShares U.S. Oil & Gas Exploration & Production ETF (IEO), and PowerShares Dynamic Energy Exploration & Production ETF (PXE). While these funds hold the large players in the industry such as Marathon Oil, Chevron, Philips 66, and ConocoPhilips, who despite the amount of debt they have, will likely be able to manage through a rate increase. They also hold the likes of Chesapeake Energy, Apache Energy, Devon Energy, Rice Energy, and Anadarko Petroleum whom all have debt levels of at 50% or more of their market capitalization. While these ETFs will be held up by the strength of the large oil and gas companies, they will also be pulled down by the weaker, smaller, higher debt ratio companies.
Utilities
Most companies in the utility industry essentially have monopolies in the region they operate. Because of this, these companies can and do take on large amounts of debt, but also are highly regulated by the government. The government decides how much prices can be increased each year, limiting the utility company from being able to change prices as they see fit when costs increase. So when interest rates go higher, the utility company can't adjust prices, which will hurt the bottom line. Additionally, because their revenue streams are very predictable, and there is a large amount of capital spending required to start a utility, large amounts of debt are taken on. Rising interest rates mean higher interest terms on that debt down the road if it needs to be refinanced. Lastly, the industry is known to pay high dividends. So times of low bond yields, these stocks are sought after and purchased by income-hungry investors. If the Fed raises rates, bond yields will move higher, allowing income investors to switch back to the safety of bonds while maintaining their current income.
The top three utility EF's based on size are, Utilities Select SPDR ETF (XLU), Vanguard Utilities ETF (VPU), and iShares U.S. Utilities ETF (IDU). Their sizes in terms of assets under management are $5.2 billion, $1.6 billion and $565 million respectively while they carry expense ratios of 0.14%, 0.12% and 0.45%. On the performance end, these ETFs have already begun to fall, but will likely fall further when the rate hike announcement is officially made. All three ETFs are down more than 3% over the last 30 days which is more than they have lost over the past 12 months, meaning investors have already begun to move out of these funds in anticipation for a rate hike.
Real Estate/Home Builders
While this industry could manage to hold itself up, the bull thinking is that a stronger economy means more home buying and higher rents on property, but it is worth noting that real estate companies and home builders will be facing stiffer headwinds if interest rates move higher. If rates begin to go up, the borrowing cost for real estate investors will be higher, thus lowering purchasing power and perhaps even hurting property values. Furthermore, higher costs due to increasing interest expense means fewer profits going to the bottom line. The same will goes for home builders because if rates move higher, the real cost of a $250,000 home goes up because of higher interest expense, meaning American's will not be able to afford as much home as before. That would cause the home builder to either sell fewer homes or lower the price of homes being sold, which will hurt margins and the bottom line.
Three of the ETFs you may want to avoid are the iShares Residential Real Estate Capped ETF (REZ), the iShares U.S Home Construction ETF (ITB), and the SPDR S&P Homebuilders ETF (XHB). The first one is more of a REIT, which will see companies hurt by refinancing debt at a higher rate and possibly paying higher prices for real estate in the future. The ITB is more of a pure-play home builder ETF as it holds the builders themselves while the XHB is a back-door play on the health of home construction as it holds assets in the paint, appliance, and other home accessory and products companies.
Final thought
Investors need to remember that a December rate hike is not guaranteed at this point, but it is safe to say that the Federal Reserve will increase interest rates sometime within the next 12 months, meaning even if the ETFs mentioned above don't decline in the coming weeks, they will likely fall over the next few months. Anyone who owns funds operating within the above-mentioned industries should begin considering other investment options.
Matt Thalman
INO.com Contributor - ETFs
Follow me on Twitter @mthalman5513
Disclosure: This contributor held long positions in Apple, Tesla, Intel, Google, Amazon.com, Facebook, Priceline and Microsoft at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.
Their not going to raise rates, their failed policies have put them in a box they can't get out of. They are going to continue jacking the markets around with their irresponsible fedspeak as long as possible, all the while enabling the insiders to get even richer while fleecing retail on these huge swings.
Nice script you wrote, but the real world is what matters. They will raise, and the pundit you copied part of that manifesto from won't ever admit he was wrong, yet again.
How do you suppose stock buy backs are going to continue propping up markets with even a 0.25% rise, where is the money going to come from once all the previously borrowed 100's of Billions @ 0.50% is rolled over, that is a 50% increase in interest? At 5% US debt service would be 1 Trillion per/yr, where is that money going to come from? At some point simple arithmetic is going to come home to roost and this unsuitability will become evident to all. Face it, we will never see 5% rates again in our life times.
Correction: I mean't unsustainability not unsuitability.
Correction,
There is away out, it is called cutting 500 billion to 1 Trillion from U.S. Federal spending.
The budget is 3-4 trillion depending on the year.
But there is no political will from the people or the congress elected by them, since it would mean
1. cut out of federal spending(states take over) on eduction
2. No EPA or a minimal one just for over sight
3. No more foreign aid except in emergences.
4. Bringing our troops all back to the states, except maybe in Korea and Japan.
I use to serve, it coast 30-50% more for each troop over seas, then it does to have them here in the U.S.
We would also get more money back from taxes, since the troops would spend their pay check locally instead of overseas.
Notice i did not say cut personal or cut defense programs, just by having them in the states will save a hug amount of money.
doing the above Will cut 500 to 1 trillion depending on how far you draw the line.
Then keep interest rates at 4% or lower for a few years until we have the debt down to reasonable size. Then raise them and we then just keep paying off a smaller and smaller debt.
The pain will have to get so bad that they will HAVE to do this, since it needs political will to do it.
BTW: "Special interests" and lobbyist groups will also have to be dealt with, since they will fight ANY cutting.
Yes, that would potentially work over time, but there is neither the time nor the will. Votes would be harder to buy and the destructive media along with the dumbed down voting public would not put up with the necessary pain for an extended enough period to make a difference. I believe we as a nation will reach a point of no return, if we have not already. If our elected officials had done the right things 7 years ago (ie, break up the big banks, jail the ones responsible for the massive fraud, claw back the ill gotten gains, restore Glass Steagle and so on), we would be over the pain by now and have an actual foundation under our economy, they just haven't the stomach for it. It is much easier and lucrative to fiat paper over the problems and leave it for the next guy to deal with. Now, 7 years later nothing is fixed, the fed has no more tools in their box and the pain will be insurmountable, NIRP anyone, I thought we needed to model ourselves after the Europeans.