Which market sectors did best when rates went up in the past

The yield on 10-year UK government bonds recently pushed through the key 5% mark to reach their highest levels since the late 1990s while 30-year yields are approaching 6%.

While this kind of environment is not typically helpful for stocks, some parts of the market have historically done better than others when rates are rising.

The UK is not alone in seeing higher borrowing costs with yields rising to decade highs across other major economies too.

Barclays analyst Ajay Rajadhyaksha commented: “Last week, long bonds broke. Not in one country. In all of them. Simultaneously. Four countries. Four different political systems. Four different central banks. But the same trade.”

With the Iranian war dragging into its third month investors are getting antsy about the potential hit to the spending power of governments, businesses and consumers alike from rising costs of borrowing.

What can we learn from prior periods of rising rates?

The last significant interest rate hiking cycle before the post-pandemic period was in 2003 when central banks responded to a cyclical upswing in the economy.

During this period the best performing sectors were cyclically sensitive areas of the market like industrials, financials and technology which outperformed defensive sectors like utilities and healthcare.

Interest rates went up in response to strong demand which is very different to the macroeconomic environment in 2022 and where we find ourselves today.

Bond yields are moving higher in anticipation of an inflationary impact from supply constraints in the Strait of Hormuz, which may force central banks to hike interest rates.

Another important contrast to the early noughties is that governments today are running budget deficits rather than surpluses and national debts are higher, which is adding to the woes for bond markets.

Which were the best performing sectors in the 2022 market fall?

The sudden reopening of the global economy after the pandemic combined with Russia’s invasion of Ukraine in February 2022 created global supply disruptions and cost pressures across many industries and this is a situation which bears greater comparison with today.

These developments gave a boost to defence companies supplying the weapons to Ukraine and the oil and gas producers like Shell and BP. Today, the situation in the Middle East is potentially even more lucrative for energy companies due to the uncertainty any reopening of the Strait of Hormuz.

BP recently told investors that every $1 dollar per barrel move in the oil price equates to a $340 million move in annual pre-tax profits.

Rising geopolitical tensions have led to further gains for aerospace and defence companies, but elevated valuations after strong gains and uncertainties over the future of warfare have led to profit taking in recent weeks.

How banks are placed this time round

The banking sector is a major beneficiary of rising interest rates. Banks earn a spread between the rate they pay depositors and the higher rate they charge for customer loans.

The current set-up for banks suggests a more nuanced outlook given the strong returns already delivered by the sector over the last five years.

There may be room for net interest margins to expand further, but this could be mitigated by slower loan growth, especially in mortgages while the risks of loan losses increase.

Insurers could get boost from higher rates

With interest rates higher today than in 2022 it may be worth keeping an eye on the insurance sector. Insurance companies collect premiums up front and invest those funds in bonds to cover future claims. Higher yields mean greater returns on new investments and older maturing bonds, which boosts profit margins.

One technical aspect in insurance accounting is that rising interest rates decrease the present value of an insurer’s liabilities, which can improve regulatory solvency ratios.

This is the minimum capital an insurer must hold to cover its future liabilities. Aggregate data from KPMG showed solvency coverage ratios have climbed to their strongest in five years.

In its first-quarter trading update in May Aviva revealed a 25% increase in operating profit, citing beneficial market movements added around 2.5 percentage points.

Traditionally defensive sectors

Sectors like healthcare and consumer staples tend to be less economically sensitive and therefore it is not surprising to see them perform well in the 2022 market fall. Their revenues tend to be more predictable and stable which protects profit margins.

The same argument applies to companies with pricing power and healthy balance sheets. This so-called quality investment style has been out of favour in recent times, so it will be interesting to see how it performs in a rising interest rate environment.

Which sectors were the worst performers in 2022?

Economically sensitive sectors like autos and chemicals performed the worst when rates starting going up in the 2022 period. Industrials and engineering firms which couldn’t easily pass on rising input costs, suffered margin compression.

Housebuilders suffered the double whammy effect of falling demand from higher mortgage costs and increased raw material costs which squeezed profit margins.

Consumer discretionary sectors including retail and leisure have historically underperformed during periods characterised by rising cost pressures and falling consumer expenditures.

Utilities are generally defensive but their high debt levels makes them particularly exposed to rising interest rates, depending on the mix of fixed and floating rate debt.

The precious metals and mining sector was one of the worst performing areas of the market in 2022. Rising interest rates are usually not helpful for the price of gold because the yellow metal does not pay interest and costs money to keep safe.

That said, gold has historically provided some protection periods of high inflation. Meanwhile silver has important industrial uses in making semiconductors and circuit boards due to the metal's good conductivity.