Interest rates are moving gradually higher, and in a well telegraphed manner. This has given investors time to focus on the impact of rising rates on their fixed income assets – strong flows into senior loans are one result. However, the equity response to monetary tightening is less clear.
To understand the potential impact of rising rates on smart beta portfolios, we reviewed the performance of factor indices over eight separate time periods in which U.S. interest rates rose by more than 100 basis points (bps). Exhibit 1.
Two trends emerged as a result of this analysis.
1. In a rising rate environment, investors rewarded companies with smaller market capitalizations and companies with attractive valuation multiples relative to their current prices.
- Specifically, the Size and Value factor indices averaged 4.7% and 2.3% in excess returns over the Russell 1000 benchmark, respectively. Exhibit 2.
- Rising interest rates typically coincide with increases in inflation and GDP growth. Seeing the potential for continued improvements in economic growth can give investors greater confidence to take on risk in the stock market, with pro-cyclical factors being rewarded.
2. On the other end of the spectrum, low volatility and higher dividend yield-oriented stocks are consistently underperforming factors when rates rise. Why might this be the case?
- Higher-yielding companies may come with higher-than-average dividend payout ratios. The Russell 1000 Yield Factor Index, for example, had a 128% dividend payout ratio as of 9/30/17.1
- Higher-yielding companies tend to use their internally generated cash flow to pay dividends, and rely on bond issuances to finance new projects. Thus, rising borrowing costs impact these companies more quickly, and investors tend to punish their shares accordingly.
- Meanwhile, low-volatility stocks underperform their benchmark as well. With the average investor looking to take on more portfolio risk amid positive GDP growth and inflation, participants look away from stocks that have historically exhibited stable return streams.
With a few notable exceptions, the factor performance trends become more pronounced over longer periods that exhibit gradual rate increases. Exhibit 3. In May of 2013, for example, then Federal Reserve (Fed) Chairman Ben Bernanke indicated that the Fed could begin reducing monthly asset purchases later that year if economic improvements seemed sustainable. This solidified support for a 164 bps 10-Year U.S. Treasury yield rise that spanned 17 months from mid-2012 through the end of 2013. In general, investors favored equities during this time period as the average single factor index returned 27%, when participants continued to bid up stocks from the lows that were reached in 2008. While Size and Value factors went up over 30%, however, yield-oriented and low-volatility stocks registered returns closer to 20%.
As always, outliers can occur, and appear more likely when the 10-year rate moves with more velocity and investors are caught off-guard. The 2004 equity response to a 3-month long, 10-year interest rate increase of 119 bps is one example. During this time, Fed Chairman Alan Greenspan proclaimed that the FOMC was ready to enact measured increases to the Fed Funds Rate, if needed, to fight inflation. With the aftermath of the tech bubble in their rearview mirror, investors may not have been prepared for this tone, and subsequently favored more defensive characteristics found in the Quality factor, such as high profitability and low leverage. The Quality index returned 3.1% during this 3-month period, while the Size premium was down 2% over the same three months – a more than 5% difference in returns.
With long rates not keeping up with Fed moves, the yield curve has flattened. If rate increases arrive without the justification of inflation, equity markets could move to be defensive, as we saw briefly in 2004, and drive even higher demand for quality stocks. On the other hand, if rate increases are accompanied by GDP growth and a pick-up in inflation, it may be prudent to expect a reversal to the Size and Value factors, especially given these factors’ relative underperformance to the rest of the market so far in 2017.
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- ^Source: Bloomberg LP, as of 9/30/17.
Alternative weighting approaches (i.e., using factor weighting as a measure), while designed to enhance potential returns, may not produce the desired results.
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