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Income Generation

Positioning equity portfolios for when rates rise

Car at Gas Stop
The current equity bull market is now more than nine years old and has survived several calls for its demise. So far, it has weathered slow improvements in economic growth, inflation expectations, a potential peak in earnings, U.S. dollar appreciation, a range of geopolitical risks and trade war/tariff concerns. Another persistent concern has often been associated with corrections or the onset of bear markets: Federal Reserve rate hikes and rising bond yields. The interest rate environment has been volatile (to say the least), but rates have been rising unevenly over the past year, and we expect that trend will persist. While this will likely contribute to market volatility, it shouldn’t spell the end of the equity bull market. It may, however, affect the way that investors access opportunities in U.S. equity markets.

Should investors expect rates to continue rise?

Since the end of the Great Recession, it has been widely expected that improving economic growth would lead to an increase in interest rates. While rates have started to rise, they have not done so consistently. This is partially due to a global environment of low (and even negative) bond yields that have suppressed rates in the United
States. And risk aversion has generally remained high among investors, prompting several flights to quality.

We expect the interest rate outlook to remain complicated and anticipate additional periods of short-term rate declines. But we also believe economic growth should continue growing modestly, which should put upward pressure on yields. While the current economic cycle is old in calendar terms, that doesn’t mean it’s coming to an end. Actuarial tables make sense for predicting human lifespans but are useless for predicting economic cycles. We don’t see the excesses that would indicate the end of the current cycle such as an inverted yield curve, rising credit spreads or rapidly rising inflation, all of which can occur before an expansion ends. At this point, we are expecting a 25 basis-point rise in December and possibly one to two more increases in 2019 as the fed funds rate approaches the neutral rate envisioned by the Fed.

Rates have been falling on and off for years, until the 10-year Treasury reached a low of 1.37% in July 2016. We believe 10-year Treasury rates are now in an environment of rising unevenly.
Equity Portfolio Infographic 1

Should investors expect rates to continue rise?
If interest rates are likely to increase, is that a negative for equity markets? Investors typically fear rising rates and think they are bad for equities, but this actually hasn’t been the case.

It is tough to pinpoint exactly when “rising rates” periods begin. In the present cycle, it can be argued that we have been in such an environment since the Federal Reserve ended its quantitative easing program, or when rates bottomed in 2016. But for purposes of historical comparison, we can analyze how equities performed after the first Fed rate hike in different tightening cycles.
Consider the past six rate hike cycles going back to the early 1980s. Using time periods of 250 trading days (roughly equivalent to one year), we found that while pockets of weakness surrounded rate hikes, equities generally weathered the storm. In most cases, equities performed well prior to times when rates rose, struggled or declined slightly after the onset of rate hikes, and then recovered and continued solid performance. The black line in Exhibit 2 represents the average performance of the S&P 500 Index during these cycles.

Equity Portfolio Infographic 2

We have also seen periods of heightened volatility when the Fed embarked on tightening cycles. In particular, a period of consolidation often accompanied the start of rate increases. In the 250 days before the first rate hike and the 500 days after, stock prices trended higher but experienced a modest selloff. The data is different for each of the six time periods, but on average, equities have experienced a peak-totrough decline of roughly 10%. This development is known among traders as “three steps and a stumble,” an anecdotal trend pointing to market declines after a third Fed rate move higher.

So far, the current cycle has more or less followed this historical trend. Since the first rate hike in December 2015 (the blue line in Exhibit 2), stock prices experienced some pullbacks but managed to grind higher.

It matters why rates rise
History is a good starting point for considering how equities might respond to rising interest rates, but we also must look closely at today’s markets. Interest rates can rise for many reasons — and those reasons can affect how equity markets perform.
For example, if the U.S. were in the midst of an inflation scare, as in the 1970s, interest rates would rise while equity prices fell. Conversely, if interest rates are rising due to improving economic growth, that would probably be good for stock prices. As a result, we sometimes see positive correlations between rising rates and higher equity prices, while at other times we see negative correlations, as shown in Exhibit 3. For the most part, we believe the current backdrop should lead to a positive correlation.

Equity Portfolio Infographic 3

In addition, we think U.S. stocks should benefit from the interest rate “starting point” in this cycle. This current cycle represents the first time in history that the Fed is raising rates from such a low level. And at the same time, bond yields are much lower than during other rate increase cycles.
We think this is important, since periods of low and upward moving rates may be a good backdrop for equities. Exhibit 4 divides the average historical monthly S&P 500 Index performance based on the 10-year Treasury yield during times of rising and falling rates. Not surprisingly, equities fared poorly when yields were high and moving higher, but performed well when yields were decreasing from elevated levels. Interestingly, stock prices also tended to rise significantly when yields were low and starting to move higher.

Equity Portfolio Infographic 4
While the 10-year Treasury yield has risen appreciably in the past year, it remains low by historic standards at around 3%. We don’t yet believe that a further modest rise in rates from here will preclude stock prices from moving higher as long as the economy continues to grow.
Investment selectivity: which areas of the market might benefit?
We don’t believe equities as a whole are likely to suffer during the current period of rising rates, but different areas of the market will likely perform better than others. The closing section of this paper offers our individual views and investment themes.
Consider sector performance, for example. In periods of rising rates, equity valuations tend not to expand, so earnings growth becomes the main driver of equity returns. Not surprisingly, sectors that tend to exhibit better growth prospects, such as financials or technology, have generally outperformed during periods of rising rates. Conversely, areas that are incomedriven and act as bond proxies, such as utilities and telecommunications services, tended to underperform, as shown in Exhibit 5.
Interestingly, equity markets appear to be more affected than usual by changes in bond yields today than they have in the past. Exhibit 5 shows a higher correlation between equity market sectors and changes in the 10-year Treasury yield over the last five years than over the last 30 years — in both a positive and negative direction.

Equity Portfolio Infographic 5
This is likely because Fed policy has heavily influenced economic growth in the post-crisis environment, and changes in bond yields at such low levels may have had an outsized influence on global financial markets in general. In any case, we expect these correlations to remain high for the time being.

Equity Portfolio Infographic 6
All rising rate environments are different, and the current cycle is unique in that rates started from an all-time low and have taken nearly twice as long to move a little more than half that of the previous seven tightening cycles, as shown in Exhibit 6. The one thing all rate hiking cycles have in common however, is that the average cost of capital increases. When this happens, equity markets tend to rely on earnings growth as opposed to valuation expansion as a primary source of return. This environment favors highquality companies that have a capital advantage over their peers, such as those that have been able to consistently grow their dividend. While this rate hiking cycle has been different in both length and intensity, dividend growers have historically outperformed during periods of rising rates (Exhibit 7).

Equity Portfolio Infographic 7
Next steps: the benefits of selectivity and active management
When interest rates and yields rise, equity investing may grow more complicated. But we believe opportunities still exist. Rising rates do not necessarily lead to market pullbacks, and even when they do, those pullbacks are likely to be temporary. Additionally, we believe changes in the interest rate and yield environment have affected intra-market moves across sectors and across differing dividend yields. We expect this trend to continue.
In particular, we believe some areas of the market are more likely than others to outperform, meaning selectivity and active management within equities could grow in importance. Below, we highlight some of our individual views and thoughts about how we are approaching equity markets:
Bob Doll, CFA
  • Changes in the interest rate and yield environment can be an important factor driving equity returns — and these changes make some factors more or less important when looking for attractively valued companies with improving fundamentals.
  • In general, we have been focusing more on cyclical sectors and value areas of the market as interest rates have moved unevenly higher since the middle of 2017. These parts of the market tend to perform better when economic growth improves and when interest rates rise. We found that these areas tended to outperform when rates moved higher (such as toward the end of 2016) but did less well when rates stopped rising or fell (such as during periodic flights to quality, which we experienced recently).
  • From a sector perspective, we’re seeing some solid opportunities in the information technology, consumer discretionary and communications services sectors. At the same time, we have a mostly unfavorable view toward utilities, real estate and consumer staples, which tend to act more like bond proxies.
Karen Bowie, CFA
  • In our view, the current interest rate environment is good for equity markets, because it shows an expanding economy. Yields are rising, but they remain close to historically low levels. And we think low-but-rising yields favor stocks. In our opinion, the 10-year Treasury yield would need to rise to 4% or 5% before it would act as a drag on stock prices. At that point, equity market multiples may begin to contract.
  • We would focus on areas where companies have strong balance sheets and that would benefit from rising rates. An example would be banks that are showing loan growth and have the ability to reprice loans versus fixed rate loans. In contrast, we would be underweight REITs, which would require higher borrowing costs and could be at a disadvantage.
  • We also see opportunities from a capitalization perspective. Small cap stocks have lagged large cap stocks notably this year. We think that trend should reverse as rates rise. Higher interest rates in the U.S. may also cause the dollar to increase, which should offer a relative advantage to small caps over large-cap companies.
Jim Boothe, CFA
  • Investors have always been attracted to the income provided by high-dividend yielding stocks, but as interest rates dropped to all-time lows in the wake of the financial crisis, the demand for income increased. During this prolonged low interest rate environment, investors have shown a willingness to pay a premium for high-dividend-yielding companies, driving up valuations while driving overall yields lower. This has made it increasingly difficult for most value investors with income mandates to manage a strategy that maintains a targeted yield bias. In order to maintain a yield mandate, investors have been forced to significantly increase allocations to higher yielding “bond proxy” sectors with higher average payout ratios. The companies within these sectors typically have lower earnings growth prospects and greater interest rate sensitivity.
  • As interest rates continue to slowly increase, we expect the primary driver of equity returns to transition away from valuation expansion and more towards quality earnings growth. In contrast to high-dividend yielders, high-dividend growers typically offer attractive earnings growth potential and have historically been among the best-performing segments of the equity market in rising interest rate environments.
  • We favor a total return approach over absolute dividend yield in this market. A diversified portfolio of high-quality dividend growth companies may be an optimal equity strategy for the later stages of a business cycle as it allows for meaningful participation in the continuation of earnings acceleration while historically providing less interest rate sensitivity and better downside in the event of heightened volatility or a market pullback.
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Dimitrios Stathopoulos
United States
Definitions
S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. Standard Deviation is a measure of the degree to which an investment’s actual returns varied from its average return over a certain period. The smaller the variation, the lower the standard deviation will be. The standard deviation is a common measure of volatility and risk. Correlation is a statistical measure of how two variables move in relation to each other. Perfect positive correlation (a correlation co-efficient of +1) implies that as one factor moves the other factor will move in lockstep, in the same direction. Alternatively, perfect negative correlation (a correlation co-efficient of –1) means that variables will move by an equal amount in the opposite direction.

Risks and other important considerations
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors. This information represents the opinions of Nuveen Asset Management, TIAA Investments and Santa Barbara Asset Management and is not intended to be a forecast of future events and this is no guarantee of any future result. Information was obtained from third-party sources, which we believe to be reliable but are not guaranteed as to their accuracy or completeness. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Past performance is no guarantee of future results.

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Santa Barbara Asset Management, LLC and Nuveen Asset Management, LLC are registered investment advisers and affiliates of Nuveen, LLC.