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Sectors to watch once Fed ends rate cycle


Don't expect any surprises when Federal Reserve policy-makers meet again this week.

Many on Wall Street agree that the central bank will raise the federal funds rate another quarter point to 3.25 percent Thursday when they announce the outcome of their two-day meeting.

After that, however, all bets are off. That presents something of a conundrum for investors, but there are patterns of stocks that tend to lag or outperform once the Fed stops its series of rate increases.

Recent economic data have sent contradictory signals. Some indicators presage a slowdown, others suggest the expansion still has sturdy legs.

The bond market seems to believe that inflation is under control. But Federal Reserve Chairman Alan Greenspan keeps suggesting the Fed must remain vigilant.

It hasn't helped that recent Fed statements have been more confounding than usual. Several weeks ago, Richard W. Fisher, the freshly appointed president of the Dallas Fed, told an interviewer that the central bank was in the "eighth inning of a tightening cycle," suggesting that there may be only one or two rate increases left.

But other Fed officials have been much more cautious. Thomas M. Hoenig of the Kansas City Fed said the central bank would like to adjust economic policy to "neutral," meaning that it is neither stimulating nor restrictive. That, he indicated, would probably mean interest rates somewhere between 3.5 percent and 4.5 percent.

Unless you happen to be an economist or day trader, however, this sort of fine-grained debate isn't particularly useful. For investors thinking about how best to adjust their portfolios to take advantage of the shifting economic picture, a broader view of the interest rate environment probably makes more sense.

Many economists believe the Fed has probably entered the late stages of the current tightening cycle. Fisher of the Dallas Fed may have gotten a little ahead of himself, but his comments demonstrate that the Fed is increasingly wary that sky-high oil prices and sluggish global growth may further crimp the economy.

"Our models suggest the Fed is near the end," said Tobias Levkovich, chief U.S. equity strategist at Citigroup's Smith Barney. "Does the Fed really want to cause a recession?"

Economic uncertainty generally produces a choppy market. But if historical trends hold true, certain groups of stocks are likely to outperform others as the economy downshifts and the Fed lets off the brakes.

Companies like banks and insurers that profit less when rates go up tend to find relief when the rate raising stops. And as the economy settles into a period of slower growth, so-called defensive stocks like health care and food companies tend to do well since they supply life's necessities and are less tied to the economic cycle.

Merrill Lynch has determined which sectors have performed best and worst as similar tightening cycles have unfolded during the past 20 years.

Before the Fed starts tightening, and even in the early stages of rising rates, cyclical stocks like durable goods producers tend to take off as companies benefit from the same economic expansion the Fed fears might overheat. The data show that forestry, oil and gas, machinery and chemical stocks lead the pack during this period. Banks, beverage companies and food and drug retailers tend to do badly.

As the end of the rate-raising cycle approaches, however, that pattern tends to reverse itself as investors start to anticipate that the economy is going to slow down because of the higher interest rates.

In the late stages of the cycle, those beverage and food stocks begin to take off. After the Fed stops, banks, insurers, utilities and computer stocks perform best, while aerospace, auto stocks, chemicals and building materials slow down sharply.

Michael Oneal is a staff reporter at the Chicago Tribune, a Tribune Publishing newspaper.

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