With December 16 marking the last opportunity for the Federal Reserve (Fed)
to raise interest rates
in 2015, market participants now put the odds of a Fed rate hike in December at nearly 80%—up from the 32% probability given to a rate hike just three months ago in September. I believe the Fed will initiate its first rate hike when it meets this week.
How have major asset classes in the U.S. performed when interest rates have risen in the past?
Going back to July of 1993, the U.S. economy has experienced nine periods when investors pushed interest rates higher on the 10-Year U.S. 10 Year Treasury Note
. The table below illustrates the annualized returns for major asset classes going back two decades, as well as their cumulative and average returns during those nine periods when yields on 10-Year Treasuries increased.
Performance during Periods of Rising Rates (10/15/1993 to 9/30/2015)
Average Annual Total Returns
For definitions of indexes in the chart, please visit our glossary.
Generally, stocks and high-yield bonds
have done well, while U.S. Treasury notes
have struggled in such environments.
On the fixed income side, not surprisingly, in each and every one of the nine rising rate periods, the U.S 10-Year Treasury lost value. On average, Treasuries lost 8.1% over the rising rate periods. Similarly, we see that the Barclays U.S. Aggregate Index
lost 2.1% on average when rates rose back to 1993. Historically, higher-yielding corporate bonds
have been the place to be when rates have risen. The BofA Merrill Lynch High Yield Index
, for example, generated positive returns in eight of the nine rising rate periods, posting an average gain of 6.0% during rising rate periods. Generally, a good time to hold high-yield bonds is when the economy is strengthening, as an expanding economic pie normally lowers default risk for individual corporate issuers. Interestingly, the only period when high-yield bonds did not advance was in 2013. It’s quite possible that the backup in rates that year was not a prelude to a stronger period of economic growth, but merely a reaction, a “taper tantrum,” to signals from the Fed that it would begin winding down quantitative easing (EQ)
later that year.
On the equity side of the equation, history provides us with some key takeaways.
We see that the S&P 500 Index
advanced in all nine rising rate periods and that its average return over those periods, 9.8%, was about 110 basis points (bps)
higher than its annualized return over the entire period. Also noteworthy, growth stocks
beat value stocks
in six of the nine periods. Moreover, unlike value, growth stocks (as measured by the Russell 1000 Growth Index
) generated an average return in rising rate periods that was higher than its annualized returns over the entire period.
During these nine previous rising rate environments, of all the asset classes tested, the one that outperformed all others was small caps. Small caps, as measured by the Russell 2000 Index
, have historically returned 15.1% on average over the last nine rising rate periods—650 bps higher than its annualized return over the entire period. This significant outperformance during rising rate environments debunks the myth that small-cap companies are best owned when the economy is just emerging from recession.
But while this historical data in rising rate environments is certainly compelling for equities, and especially for small caps, the $64,000 question is whether “history will rhyme” this time around. Put another way, is the U.S. economy as strong as it was in past cycles when the Fed rose rates and investors pushed up long-term yields? Or are there forces afoot in the U.S. and global economy that will make this time different? I will explore that question in a future blog post.
With respect to what has transpired in the recent past, the record shows that equities generally have performed well during rising rate environments and those investors who have tilted toward growth and small caps during such periods have been rewarded for doing so.