Rate hike could boost bank stocks

With the Federal Open Market Committee expected to announce a hike in the federal-funds rate this Wednesday, investors have been on edge over the move's potential impact on stock prices.

There have been nine times in the past 50 years that theFederal Reserve raised short-term interest rates more than once in a rate-tightening cycle (using the discount rate from 1967-1990, and the fed funds rate thereafter). Six months after these initial rate increases, the S&P 500 declined about 3 percent, having fallen in price five times, but rising four times. Stocks slipped the most within the first six months following the first rate hike in 1987, while climbing the highest after the first hike in 1980.

The greatest number of sectors rose in price following the 2004 rate-tightening cycle. Digging a little deeper, we see that, on average, S&P 500 growth stocks declined less than value stocks, but posted similar frequencies of outpacing the broader market. On a sector basis, energy, information technology, and telecom services recorded average price increases during these periods, each beating the market more than 50 percent of the time (telecom services' history only covers four of the nine cycles examined).

Pedestrians walk in front of a Citibank branch in New York.
Scott Mlyn | CNBC
Pedestrians walk in front of a Citibank branch in New York.

The worst performances came from materials (which beat the market only 44 percent of the time and recorded an average return of -3 percent), followed by industrials (44 percent, -4 percent), utilities (33 percent, -4 percent) and financials (33 percent, -7 percent). Within the financials sector, all 10 sub-industries recorded negative average returns. For those groups participating in all nine initial rate hikes, they beat the market as little as 11 percent of the time (S&Ls) to as much as 44 percent (major regional banks).

Since banks make up the bulk of the S&P 500 financials sector's weighting, the natural question is "How will the banks do in the six months after the Fed starts to raise rates this time around? Will they record double-digit declines, such as in 1977, 1987 and 1999, or keep their heads above water, as was done in 1967, 1980 and 2004?" Erik Oja, S&P Capital IQ's banking analyst, offers the following assessment and outlook.

In the past, bank stocks underperformed the overall market while the Fed raised short-term interest rates. That's because rising short-term interest rates, combined with stable long-term rates, have almost always led to narrower net interest spreads, which is the profit rate that banks make on loans. Once the Fed has finished hiking short-term rates, however, long-term rates have typically risen, leading to wider net interest rate spreads, and bank stock outperformance.

We think this time is different. The Fed will likely start raising rates this month, in an attempt to recalibrate, not restrain. In other words, the Fed is not trying to slow down a fast-growing economy or dampen runaway inflation.

The economy is projected by Standard & Poor's Economics to grow 2.7 percent in 2016, below historical growth rates, while inflation remains well under control, due to energy price declines. This time the Fed is looking to increase rates to prevent speculative asset bubbles from developing further. Banks have had years to re-orient their balance sheets toward the short end of the yield curve.

The largest banks have significant amounts of their assets in federal-funds securities and other extremely low-yielding investments, which have been required by the Basel III capital rules and liquidity requirements. We therefore think the very largest banks, including JPMorgan Chase, Bank of America, Citigroup and Wells Fargo will immediately benefit from rising short-term interest rates.

If the Fed goes ahead with a rate hike on Wednesday, December 16, we expect to see their stocks rise faster than the market. We also think regional banks will benefit from rising short-term rates.

Commentary by Sam Stovall, U.S. equity strategist, S&P Capital IQ and and author of "The Seven Rules of Wall Street." Follow him on Twitter @StovallSPCAPIQ