Advisors well know that March will likely bring the first of the Federal Reserve's 2022 interest rate hikes. They also know that rising rates aren't necessarily a drag on stocks.
It's also known that some segments of the equity market capitalize on Fed tightening, others struggle and others are usually neutral. Expounding upon that concept, advisors may want to consider factor strategies against the backdrop of rising rates and that's limited to embracing value over growth, though that is working this year.
Specifically, advisors might want to evaluate how high beta and low volatility stocks perform as rates rise. Making this objective easier is the fact there are a variety of exchange traded funds dedicated to these factors. Additionally, low volatility is highly relevant today due to inflation in the U.S. and geopolitical conflict elsewhere.
Indeed, high beta and low volatility are distinct concepts, but it is worth investigating how one of these factors, perhaps both, could benefit client portfolios as Fed tightening lurks.
Settling the Score
First, it pays for advisors to discuss with clients that stocks can prove durable when rates rise. Better yet, have the data to back up that assertion.
“Conventional wisdom has been that rising interest rates should be bad for the stock market. But recent history has shown that that’s not necessarily the case. From 1991 through 2021, there have been 156 months when the 10-Year U.S. Treasury Yield rose,” according to S&P Dow Jones Indices. “Of these, the S&P 500® gained in 115 (74%) of the months and declined in 41—i.e., in a rising rate environment, the market was more than twice as likely to do well as badly. The common belief that there is an inverse relationship between interest rates and equity market performance is no longer a sure thing.”
Now, consider examples of rates and stocks falling in unison. In those examples, low volatility performs less poorly than high beta.
“In months when interest rates fell and the equity market also fell, the S&P 500 declined by an average of 3.8%%,” adds S&P. “The average outperformance of the S&P 500 Low Volatility Index was 2.3% in those months, while the average underperformance of the S&P 500 High Beta Index was 4.0%.”
Good News: Rates Aren't as Important as Clients Think
Another point to convey to clients is that interest rates are more impactful for bonds than to stocks. Advisors know this and probably find it obvious, but many clients don't. Hence, their jitters as it pertains to stocks and rates.
That relevance of stocks vs. rates and bonds vs. rates is relevant in the factor conversation because rates aren't primary drivers of high beta or low volatility performance, which should be a relief to clients.
“For strategies that are explicitly risk attenuators (like Low Volatility) or risk amplifiers (like High Beta), the condition of the equity market is much more important than the state of the bond market. For example, Low Volatility tends to outperform in bad markets while lagging in good markets, and High Beta tends to exhibit the opposite pattern of returns, regardless of whether interest rates are rising or falling,” concludes S&P Dow Jones.