ETF Trends
ETF Trends

This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.

US employers added 280,000 jobs in May – the largest hiring gain since December. This encouraging report from the US Labor Department, coupled with stronger-than-expected gains in hourly earnings, has renewed expectations for tighter monetary policy over the coming year. The Federal Reserve has been forthcoming about the need to normalize monetary policy, and investors are now preparing for higher interest rates.

This begs the question of where money will flow in the second half of 2015. A look at the historical performance of sectors within the S&P 500 Index is no guarantee of future results, but does provide interesting clues.

Historical sector performance in a rising rate environment

The table below shows the correlation between interest rates — represented by 10-year Treasury note yields — and economic sectors within the S&P 500 Index. Sector correlation is shown over five-year, 10-year and 20-year periods, with the simple average correlation also shown.

  • Cyclical sectors like energy, industrials, information technology and materials have historically shown the strongest correlations to interest rates. This makes sense, given that inflationary pressures and higher interest rates often come on the heels of strong economic growth — the same growth that benefits economically sensitive sectors. A strong economy is likely to boost capital spending, which should bode well for IT shares. However, one of the challenges facing the energy sector is a near-term glut in crude oil supply.
  • Financials also show strong correlation to the 10-year Treasury yield – with the relationship particularly close over the past five years. Given the zero interest rate environment we’ve seen since 2008, net interest margins (the difference between interest income that financial institutions generate and the interest they pay to lenders) have been depressed. Correspondingly, net interest margins should benefit from higher interest rates. Many market participants realize this and have pushed bank shares, as defined by the KBW Bank Index, above their one-year trading range in recent days. In my view, it’s definitely a good time to own bank stocks.
  • Consumer discretionary shares have also gained during periods of rising interest rates, although the correlation is not nearly as strong as with financials.
  • As you might expect, defensive sectors like consumer staples, telecommunication services and health care have demonstrated tepid correlation to rising interest rates. Not shown in the table is the performance of industries underlying these sectors. Within health care, biotech is a particularly crowded field, and has shown a negative correlation to interest rates. It would not be surprising to see defensive sectors underperform more economically cyclical sectors when rates go higher.
  • At the back of the pack are utilities, which have shown an inverse correlation to 10-year Treasury yields over the past five years. Utility company issues are among the worst performing components of the S&P 500 Index so far in 2015. Reflecting their underlying indexes, many exchanged-traded funds (ETFs) with dynamic sector allocation, including the PowerShares S&P 500 Low Volatility Fund (SPLV), have significantly reduced their exposure to utilities over the past two years in anticipation of higher interest rates.

Note that the S&P 500 Index is, on average, positively correlated to the 10-year Treasury yield. This might surprise many investors who assume restrictive monetary policy is a detriment to stock performance. There is little doubt that higher interest rates will generate increased near-term volatility, and investors should position themselves accordingly. But history also shows that large-company returns have been correlated to higher rates over longer periods of time.

Investment ideas for a rising interest rate environment

After consulting with a financial advisor, investors anticipating higher interest rates may wish to consider smart beta ETFs with dynamic sector allocation and strong interest rate sensitivity. The PowerShares KBW Bank Portfolio (KBWB), the PowerShares KBW Regional Banking Portfolio (KBWR), and the PowerShares KBW Insurance Portfolio (KBWI) are particularly well-positioned within the financial sector. The PowerShares S&P 500 High Beta Portfolio (SPHB) has a significant allocation in economically cyclical stocks. PowerShares DWA Momentum ETFs are factor-driven portfolios that may also benefit from rising rates. And given the potential for market turbulence in the months ahead, investors may also wish to consider a low volatility strategy. The PowerShares S&P 500 Low Volatility Portfolio (SPLV) invests at least 90% of its assets in the lowest realized volatility common stocks of the S&P 500 Index, and is strongly correlated to the 10-year Treasury yield.

Learn more about the sector exposure of PowerShares ETFs using our exposure comparison tool.