Rising Rates Open New Vistas for Stock Pickers

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-RATE CHAMPIONS

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).