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By Matthew Coffina, CFA and Jeremy Glaser | 09-23-2015 04:00 PM

Coffina: Investors' Rate-Hike Fears Overblown

Stock-pickers using reasonable interest-rate assumptions can find opportunity among beaten-down utilities and REITs, says Morningstar's Matt Coffina.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Have concerns over the Fed raising short-term interest rates created any buying opportunities? I'm joined today by Matt Coffina--the editor of Morningstar StockInvestor newsletter--to find out.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me.

Glaser: Let's talk about their short-term concerns first. Why do investors seem somewhat obsessed over when the Fed is going to raise interest rates? Does a 25-basis-point rise in that short-term rate really make a difference to the market?

Coffina: I don't think a 25-basis-point change really changes much one way or another, but I think investors have become very much focused on monetary policy over the last decade. We've had this very unusual period of zero interest rates for the past six years. I think a lot of investors think that that has propped up the stock market and maybe has been one of the main drivers of the bull market that we've had. So, I think investors are on edge about what it means when some of that stimulus is taken away.

Certainly, rates do affect the fair values of stocks, so you have direct effects--for example, your interest expense tends to go up with a higher interest rate. But then more importantly, you have indirect effects, such as your cost of equity also tending to go up. Investors demand a higher return, bonds become relatively more attractive, and so to invest in stocks, you need to be compensated even more so than before. Again, I don't think a 25-basis-point change makes a difference, but investors are worried about where rates are going over the long run and, more importantly, what this means for investor sentiment and how investors are going to see stocks relative to their alternatives.

Glaser: When you look at how Morningstar values stocks, what do we assume in terms of long-term rates? What's already priced in?

Coffina: We have an explicit assumption for the long-term Treasury yield in a normalized environment--and that's 4.5%. So, it's about double what the long-term Treasury is trading at right now. If the 10-year Treasury goes to 4.5%, it would meet our expectations. If it went higher than that, we might have to consider cutting fair value estimates; if it stayed lower than that indefinitely, we might have to consider raising fair value estimates. But as a base case, I think 4.5% is a reasonable number to keep in mind. We base that on about 2.25% over real return--and, by the way, bond investors haven't had any kind of real return in recent years--and then about 2.25% inflation in a more normal environment.

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