Calibrate responses to current conditions.
While it’s important to know how to manage your clients’ investments through a period of rising interest rates,1 don’t take your eyes off the other side of the pendulum. The strong economic growth that leads to rising rates will inevitably be followed by a recession and a period of falling rates. Importantly, the strategies that you may be considering today to mitigate the risk of rising rates might have the side effect of exacerbating your downside in the next bear market. So, unless you have incredible market timing skills (and let’s just assume that you don’t for the purposes of this article…if you do, let’s grab a drink sometime), you’ll want to be careful in calibrating your response to current conditions.
Interest Rates and Recessions
In evaluating strategies that can be defensive in bear markets, let’s take a look at the three recessions and seven market declines of 15 percent or more (bear markets) that have occurred in the United States since 1986. Each recession has been accompanied by a bear market, but not every bear market is due to a recession. While interest rates have been in a secular decline during this period, they have a tendency to rise during the good times (the current worry), but fall during the recessions and bear markets.
Bond Investment Choices
Given the current risk of rising rates and a flattening yield curve, the conventional wisdom is to shorten bond duration (a measure of the interest rate sensitivity of your portfolio roughly corresponding to the maturity of a bond). Long-term bonds lock you into the current interest rate, and you forgo the ability to benefit from new, higher yields. Thus, the price of longer term bonds will drop when interest rates rise as investors prefer new issues (assuming same issuer or comparable risk). Investors may even be considering going to cash. As of this writing, cash yields are about 2 percent, while 10-year Treasury yields are less than 3 percent. You’re not getting paid a lot extra to lock in your interest payment.
The other strategy investors are considering is taking on more credit risk. Perhaps it’s better to get an extra 2 percent of yield by buying a low rated, but short-term, bond so that your client can get an increased interest income without subjecting himself to impairment from rising rates. Should the economy stay strong, there’s less risk of default.
Now, let’s take a look at what may happen if you sustain that position into the next recession or bear market. “When Are Investors Better Off?” p. 53, shows the cumulative investment returns during each of those periods for intermediate duration bonds, cash and high yield bonds. Because interest rates have tended to fall in these periods and less creditworthy borrowers will be under more stress, high quality intermediate duration bonds did better in every one of these historical events. During recessions, investors have been better off in bonds by 4 percent relative to cash and by 7 percent relative to high yield. During bear markets, investors have been better off by, on average, 5 percent relative to cash and 14 percent relative to high yield.
The counter argument might be, “That’s all well and good, but won’t I get killed during the rising rate part of the cycle?” It’s true that bonds underperform cash when rates are rising. However, you’re still likely to have positive returns. “Surprise, Surprise,” p. 54, shows the return of the Bloomberg Barclays Aggregate during the past seven times when the Fed was raising rates. Note that there’s only one period when bonds lost money … and that loss was fairly small.
For investors that have portfolios inclusive of both stocks and bonds (that is, most investors), the fact that bonds have done better during bear markets is particularly important given that, by definition, stocks had a significant decline during the bear market. This superior bond return came at the most important time to help minimize the downward movement of one’s overall wealth. Now, let’s take a look at strategies to consider within your client’s stock portfolio.
Equity Investment Choices
Recently, stock market results have been driven by technology and other growth-oriented companies, while more defensive, income-oriented sectors have lagged. “Sector Relative Return,” p. 55, shows the results by sector during the last seven bear markets and sorts the sectors by the frequency that they outpaced overall market returns.
Consumer staples and utilities are the only sectors to have outperformed during each of the bear markets. We also see high probabilities of success from health care and telecommunications. On the other hand, not only have more cyclical sectors like industrials and materials tended to lag but also have some of the growth sectors such as consumer discretionary and technology. This makes sense as consumers and businesses might defer discretionary spending while times are tough, but are hesitant to pull back on essentials. There are definitely worries that consumer staples may not hold up well in the future as they have in the past due to the growth of the Internet and the “Amazon effect,” so you need to carefully evaluate individual investments.
Let’s also analyze factor returns for clues regarding what might hold up well. Factors are measurable characteristics of each company. In “Factor Relative Return,” p. 55, the U.S. equity universe is broken into five equally weighted quintiles. The numbers in the chart represent the average return of the top 20 percent minus the average return of the bottom 20 percent. For example, volatility (companies whose share prices show the most fluctuation) has been a negative for all bear markets meaning that, on average, the highest volatility companies did much worse than the lowest volatility companies. Observe that investing behind volatility and momentum (the trend that companies that have been rising the fastest recently will continue to do so) can be quite harmful when the market turns.
Yield (investing in companies with the highest dividend yields), return on equity (a measure of profitability) and quality growth (investing in companies that have had consistent earnings per share growth and a high return on assets relative to peers) have held up the best. Higher yielding stocks have lagged significantly this year as they’re also vulnerable to rising interest rates. As rates rise, bonds become a better alternative for income-seeking investors.
Another interesting observation is that while value (investing in companies with cheaper prices) worked well during the first four bear markets, it’s been less effective since the financial crisis.
This data should be a caution flag for investors who might want to pile into the “FAANG” stocks (Facebook, Amazon, Apple, Netflix, Google) that have been leading the market higher. While these stocks exhibit a lot of quality growth characteristics, they could be vulnerable due to their momentum and volatility. Investors may want to consider trimming these holdings and adding to their more income-oriented equity services.
Consider Risks and Rewards
While no one likes to give up potential returns during the heady days of a bull market, we also know that investors are highly risk averse, and there’s nothing more painful than losing money … and nothing more harmful to a client relationship than underperforming during a bear market. Maintaining sufficient allocations to high quality intermediate duration bonds, defensive sectors such as utilities and consumer staples and factors such as quality, profitability and yield can both help grow client’s wealth should the bull market continue and mitigate the downside in bear markets. Advisors will want to ensure that actions taken today to reduce the risk of rising interest rates don’t create bigger problems during the bear market to come.
—The views expressed herein are those of the author and do not necessarily reflect the views of Capital Group Private Client Services and should not be construed as advice. The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable and are subject to change at any time. There is no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results.
Endnote
1. Elizabeth K. Miller and Andrew N. King, “Positioning Portfolios for a Rising Rate Environment,” Trusts & Estates (September 2018), at p. 45.