Investing in a Rising Rate Environment

Russ Koesterich, Global Chief Investment Strategist

US interest rates have spiked sharply higher in recent months. The yield on the US 10-year Treasury is now more than 100 bps above last summer’s all-time low. For investors, this has important implications, potentially creating an investment landscape not seen in years—and impacting both stocks and bonds. This paper takes a look at what this means for investors, focusing on three areas:

1. Why Rates Are Rising

Higher rates are not, as some might have expected a few years ago, a function of rising inflation expectations. By virtually every measure, inflation is flat or falling and investors have been downgrading their expectations for future inflation. Instead, rising real rates are responsible for the backup in nominal yields. As investors have repriced the timing and pace of a Federal Reserve (Fed) “tapering,” real rates have risen from negative territory and are slowly normalizing, albeit at still low levels.

2. The Outlook For Rates

While we expect this process to continue over the next 12 to 18 months, we do not expect a “melt-up” in interest rates. There are several headwinds to a quick rise in rates, including: short-term rates still anchored at zero, few inflationary pressures, a dearth of private sector supply due to the ongoing deleveraging, less issuance from the US government thanks to smaller deficits, significant buying by other central banks, and demographics.

3. What It Means For Investors

We don’t believe we are facing the bond market meltdown that some fear, but even a modest backup in yields will have a significant impact on asset allocation:

• Within fixed income portfolios, lower duration and employ more flexible strategies.
• Raise the allocation to equities: While not a panacea, in the past equities have offered some diversification and have outperformed bonds in a rising rate environment.
• Within equities, investors should avoid heavily indebted sectors and those viewed as bond proxies, which are the most vulnerable to multiple compression.
• From a style perspective, large and mega cap valuations typically withstand rising real yields better than small and mid-cap names.

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