Positioning for Rising Rates

Investing

Why rates are likely to keep rising

  • When combined with healthy growth and ballooning government deficits, it suggests that interest rates will likely continue to rise
  • Economy is also picking up momentum: US GDP growth has accelerated from 1.5% in 2016 to 2.3% in 2017 and we expect 2.9% this year
  • Unemployment rate hit 3.9% – the lowest since 2000 – and corporate earnings so far have exceeded Wall Street’s expectations with growth of 23% year-over-year – the best in 7 years
  • All this points to a healthy US economy, giving the Fed room to continue to raise rates
  • Key question for investors is: Can I really afford not to adapt to the likelihood of rising interest rate environment?

The consequences of inaction

  • Rising rates are having significant implications on asset class performance
  • Since the 10-year Treasury yield hit a low in 2016, assets typically viewed as defensive income-producing investments have actually had negative returns versus 31% returns for the S&P 500
  • Over that period, long-term Treasuries have had returns of -13% and, within stocks, high dividend-yielders such as Telecom, Staples, Real Estate, and Utilities have underperformed the S&P 500 by at least 25 percentage points
  • This underperformance includes the positive offset from the dividend, which exemplifies the need to look at total return, not just dividend yield

How should you invest when rates are rising?

  • There have really only been two major interest rate regimes in the past 65 years: a rising rate environment that favored stocks to bonds and a falling rate environment where stocks marginally outperformed bonds
  • We believe it is fair to assume the next regime is one where rates rise, which will likely favor stocks over bonds in the long term
  • When looking for stocks that pay dividends, we prefer dividend growth rather than stocks with high dividend yields but no growth

But don’t sell all your bonds just yet

  • For bondholders a 10-year Treasury rate of 3.25% at year-end should be of little concern
  • Most bond investors are buy and hold, so as long as the bond pays off at maturity, the total return on the bond is generally close to the promised yield when the bond was bought
  • Bonds also offer portfolio diversification and help control risk when stock market volatility picks up as it did recently
  • We suggest staying defensive and reducing durations while remaining invested. Cash-like instruments have historically performed well in rising rate environments. TIPS also help diversify portfolios while preserving purchasing power

What has worked well in previous rising rate regimes?

  • Commodities and stocks have done best when nominal interest rates have risen
  • Bonds – both corporate and long-term Treasuries – have fared the worst
  • Among the S&P sectors, global cyclical sectors have done best while the defensive bond proxies have had the highest probability of loss and lowest average returns
  • Among the quantitative factor groups, Risk, Value, Momentum and Growth all outperformed during the vast majority of periods of rising rates

Bank of America Merrill Lynch – Positioning for Rising Rates, May 2018

Image Source: BAML US Equity & Quant Strategy, ICE BAML Indices, Ibbotson, FactSet

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