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Real Interest Rates Are Rising. Here Are 4 Stocks That Can Still Thrive.

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Consumer-staples stocks such as Walgreens don’t suffer much in terms of sales growth even when consumers watch their budgets more closely.
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Real interest rates are rising, which can hurt stocks in several ways. But a select type of stock can still thrive. 

A real interest rate—as opposed to a plain old rate—is an interest rate minus the expected annual inflation rate. For real rates to increase, the interest rate has to increase faster than the rate of inflation is rising. That is what is already happening as investors prepare for the Federal Reserve to tackle the surge in inflation that has resulted from pandemic-related supply-chain problems and pent-up demand.

To slow the economy, the Fed’s main tool for reining in rising prices, the bank will lift the ultrashort-term federal-funds rate, bringing real short-term rates higher. Even though the fed-funds rate hasn’t begun to rise, investors are confident that they will, so they are demanding higher returns for holding riskier, longer-term debt.

That has brought the yield on 10-year Treasury debt to just above 1.8% from 1.36% at a low point in early December. With annual inflation expectations for the next 10 years unchanged at 2.4%, according to St. Louis Fed. data, the real 10- year yield has risen. It is now negative 0.66%, up from negative 1.1% in early December. 

Rising rates cause pain in all sorts of stocks. Economically sensitive value stocks can suffer to the extent that higher short-term rates slow down growth. And risky growth stocks take a hit when the real 10-year Treasury yield rises. Those names are valued on the basis of profits that will roll in 10 years or more into the future, so they become less appealing when returns on low-risk government bonds increase. 

One type of stock can thrive: so-called quality value stocks whose earnings can withstand any economic turbulence brought on by higher interest rates. Those stocks are valued more reasonably in terms of their prices relative to anticipated per-share earnings.

Higher real yields “reinforced our preference for lower price/earnings, “quality,” companies as a place to weather the current high-rate/declining multiple storm,” wrote Tom Essaye, founder of Sevens Report Research, in a Tuesday research note. 

22VResearch, an investment-research firm, compiled a list of stocks that fit Essaye’s description. It looked at the historical correlation of single stocks in the S&P 500 to changes in both the real fed-funds rate and real 10-year Treasury yield. Here are four companies that move most closely in line with real rates, with stock-price gains as rates rise. All four trade for lower multiples than for the S&P 500 as a whole, aren’t economically sensitive, and have already outperformed the index this year.

Walgreens Boots Alliance (WBA) has the highest correlation to both the real fed funds and 10-year Treasury rates, at 1.58. It trades at 10.6 times analysts’ average earnings per share projection for the next year, versus the S&P 500’s 20 times. And it is in the consumer-staples business, which doesn’t see much of a hit to sales growth even when consumer watch their budgets more closely. The stock has risen 0.8% year to date, while the S&P 500 is down 4.5%. 

Vertex Pharmaceuticals (VRTX) has the second highest correlation, at 1.56. The drugmaker’s stock trades at 17 times earnings and is up 4.2% this year. 

Viatris (VTRS) has the fourth-highest correlation, at 1.53. The diversified drugmaker’s stock trades at four times earnings and is up 4.2%. 

Medtronic‘s (MDT) 1.45 correlation is the sixth highest. The medical-device manufacturer’s stock trades at 17 times and is up 2.3%. 

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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