Bank of America expects 7 interest rate hikes this year. Which actions should we target?

Stocks that generate strong free cash flow will be good bets for investors as the Federal Reserve
embarks on raising interest rates multiple times in 2021, according to Bank of America.

The bank’s latest forecast is for seven rate hikes this year as the Fed aims to quell scorching inflation. The Fed’s signal for an aggressive pace of rate hikes and quick drawdown of its balance sheet has rattled equities so far in 2021, with the S&P 500 down 6% year-to-date.

In a new note on Monday, BofA reiterated its 4,600 year-end call for the S&P 500, a target 2.5% above the benchmark’s current level. While the firm noted that Fed rate-hiking cycles have historically coincided with stock gains, it says the market is more overvalued than in past cycles, creating a more selective environment for stock-pickers.

To that end, it shared a guide for investors looking to contend with a tightening Fed rate-hiking cycle.

Savita Subramanian, BofA’s head of US equity and quant strategy, first recommends buying stocks with attractive free cash flow metrics – specifically FCF-to-enterprise value and FCF-to-price.

“High FCF based valuation strategies have ailed over the past almost decade of zero interest rates, but the factor has produced the strongest alpha of all of the valuation factors that we track over the long haul,” Subramanian wrote.

Cyclical sectors fare the best in times of rate hikes. The consumer discretionary sector has outperformed the S&P 500 in more hiking cycles than any other but it currently faces risks from rising labor costs as wage pressures intensify, the bank said. Information technology, energy, materials, and staples are other cyclical sectors that have historically done well during rate increases by the central bank.

Bond proxies, meanwhile, have fared the worst, meaning tough times for the utilities and real estate sectors. Industrials also have historically suffered in rising rate environments.

Small-caps stocks typically outperform large caps in the months leading into the first Fed rate hike. They then slightly underperform, by 1 percentage point on average, over the full hiking cycle.

However, “unlike the majority of other hiking cycles, small caps are historically cheap vs. large caps today,” BofA said.

The Federal Reserve in 1999 began drawing down its accommodative monetary policy and raising interest rates that year more than market investors had anticipated. The hiking cycle ended at 6.5% in 2000. The US economy experienced a recession during the following year.