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.
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.
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.
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.