During its March 2016 meeting, the Federal Reserve announced that it plans to raise interest rates just twice this year. That number is down from the four anticipated rate hikes projected in the Fed’s December 2015 meeting. With the U.S. economy slowing to an anemic 0.5% growth rate in the first quarter, the futures market is pricing in just a 1-in-5 chance of the central bank meeting its conservative goal of two rate hikes this year.
The good news is that there are a number of sectors that tend to benefit from the central bank’s delay in hiking interest rates, and investors can capitalize on these opportunities with sector exchange-traded funds (ETFs).
The utilities sector is one of the most obvious beneficiaries of a slower-than-expected rise in interest rates. With its traditionally high dividend yields, the sector tends to attract investors looking for higher yield during low interest rate environments. A prolonged period of low interest rates could cause investors to stick with the utilities sector as they wait for a sustained rise in interest rates. This is evidenced by the sector’s jump after the Fed’s announcement (Figure 1).
The most popular utilities ETFs include:
- Utilities Select Sector SPDR Fund (XLU ).
- Vanguard Utilities ETF (VPU ).
- First Trust Utilities AlphaDEX Fund (FXU ).
According to SPDR, XLU offers a dividend yield of 3.29%, which is significantly higher than the 30-year Treasury yield of about 2.7%.
Commercial and residential real estate investment trusts (REITs) also tend to perform well in low interest rate environments given their above-average yields. Since REITs are required to distribute 90% of their taxable earnings, they tend to offer greater yields than many other types of equities or trusts. Real estate prices also tend to appreciate during low interest rate environments since consumers can obtain cheaper mortgage loans.
According to Vanguard, the Vanguard REIT ETF (VNQ ) offers a dividend yield of 4.32%, which is higher than the 30-year Treasury yield of 2.7%. The real estate market has also benefited from strong underlying trends in home buying, homebuilding, and new home sales.
The most popular real estate ETFs include:
Key Risks Remain
The utilities and real estate sectors have been strong performers throughout the year, but these gains have come largely from the Federal Reserve revising its plans.
Consistently strong employment numbers and improving economic conditions in China could alleviate some of the central bank’s major hesitations with increasing interest rates. While expectations remain low for both rate hikes this year, many economists are confident that there will be at least one rate hike during the December meeting. Further improvements in the economy could change those odds, however, and send these sectors lower.
The Bottom Line
The Federal Reserve’s decision to slow down its plans to hike interest rates this year led investors to reconsider higher-yielding assets such as utilities and real estate. Many ETFs in the space responded by moving sharply higher when the central bank revised its plans and tend to react to any interest rate-related news. Investors may want to be careful investing in these ETFs, however, given this high level of interest rate sensitivity and economic uncertainty.