Rising Rates Open New Vistas for Stock Pickers
February 02, 2017
Rising rates are typically good for stocks, especially when they’re rising because of a strengthening economy. That should mean better days ahead for many postcrisis laggards. But a lot will depend on how inflation behaves.
After a series of head fakes, interest rates and potentially inflation appear to be coming out of their funk. Governments across the globe are shifting from monetary to fiscal stimulus to reinvigorate growth, with the US at the forefront. An array of proposed pro-business policies from the new US presidential administration—including lower corporate taxes, repatriation of cash held offshore and looser regulation—has lifted confidence in US and, in turn, global growth.
So what does all this mean for stocks? Each rate cycle has been unique, but history can give us clues to what may lie ahead.
As we wrote in the wake of the 2013 Taper Tantrum, stocks generally thrive when rates rise. Surprisingly, during the 17 bouts of rising 10-year US Treasury bond yields since 1970, our updated research shows that large-cap global stocks rose 17.4% annualized, outperforming their long-term annualized average gain by more than eight percentage points.
Rising rates have also been rewarding for active investing. Our research found that most of the common drivers of stock outperformance—notably, low valuation, high quality and high price momentum—did significantly better in rising-rate environments than they did normally (Display). These findings were similar for both US and non-US markets separately.
Value stocks were by far the biggest winners. That makes sense. Value tends to be heavily exposed to cyclical sectors of the economy (e.g., basic materials and industrials) and rate-sensitive financials. The biggest losers were stable earners and other less volatile companies in consumer goods and utilities. These Steady Eddies are beloved for their bond-like qualities when growth is scarce and yields are low. But investors tend to desert them in times of rising yields, when racier stocks offer better return potential.
Indeed, this market rotation is already in full swing, with investors shifting from positioning for deflation and a global economy dominated by monetary policy in favor of beneficiaries of reflation and stronger government spending (Display).
But here’s the catch: in many ways, we’re in uncharted territory. Since the mid- to late 1980s, inflation has been relatively benign and rising-rate episodes have been brief pauses in an unrelenting downward tumble. With rare exception, bond yields rose as policymakers reacted to early signs of an overheating economy—but not so much that rate hikes damaged corporate profitability. The most vivid outlier was the Bond Massacre of 1993−1994, when the US Federal Reserve startled markets with an unexpectedly aggressive intervention to a bout of inflation. Stocks appreciated but lagged their historical gains.
Things are different today. Though inflation bears watching, the global economy is far from overheating. Both inflation and US Treasury bond yields are recovering from rock-bottom levels following a decade of unprecedented central bank experimentation. The mechanics of the global financial markets work differently now, and the consequences of unwinding these policies are still unknown.
In the US, promised tax cuts, deregulation and higher fiscal spending, if delivered, could bolster growth. But these prescriptions are coming at a time of low unemployment and accelerating wage growth. The offsetting drag of a stronger US dollar, higher borrowing costs, and possibly new barriers to trade and immigration must also be weighed.
As important, this rate reversal follows a long bull run for stocks, particularly in the US. Valuations are elevated, likely restraining further gains from multiple expansion. We expect increased market turbulence and greater dispersion among stocks as investors negotiate the likely repercussions of unfolding policy and geopolitical changes.
A “Stay Nimble” Market
With so many crosscurrents and heightened political risks, yesterday’s playbook won’t cut it. This new regime will create winners and losers. Exchange-traded funds and passive index-tracking vehicles can’t interpret how individual companies will react to new policies or economic developments. Investors will need to be careful in how they access today’s opportunities.
Our economics and fixed-income investment teams anticipate a measured and gradual normalization of US monetary policy as the US economic recovery continues to gain traction, with a commensurate rise in US bond yields from today’s still exceptionally low levels.
So what does history tell us? Context matters in how stocks perform in rising-rate environments, with inflation a key variable. We believe that if bond yields rise in response to a stronger economy but inflation expectations remain controlled—as we expect—stocks should continue do well, particularly those of companies that can benefit from improving demand and pricing power.
But this rate cycle is unlike any of the past 40 years. While leaning into the reliable levers of past outperformance in rising-rate environments is a good starting point, investors will need to be far more selective and agile than in the past.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
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