Don’t Be Passive About Rising Rates by Chris Marx, AllianceBernstein
Though they’ve defied expectations this year, higher interest rates appear to be all but inevitable. Investors need to take measure of the rate sensitivity in their portfolios—and stay agile—to negotiate the rough market crosscurrents a rate reversal may bring.
We expect the shift to be gradual, judging from US Federal Reserve’s commitment to tying future rate increases to a sustained economic recovery. Widespread predictions that bond yields would continue to climb following last year’s uptick have proven premature, as renewed geopolitical anxieties and the still-anemic global recovery have rekindled investor affection for the safe havens of US, German, UK and even Japanese sovereign bonds.
As our research has shown, equities typically do very well when rising rates coincide with a strengthening economy. Nonetheless, a rate reversal, when it comes, will mark a significant departure from a status quo sustained by years of super-easy monetary policies and a 30-year downtrend in US Treasury bond yields. The shift will influence market yields globally—and, we think, could spark a major shift in market leadership. Investors will not want to be caught wrong-footed.
Safety Not So Safe
Stocks in some “safer” (income-oriented) industries, such as utilities, tobacco, telecom and real estate investment trusts, are the most obviously vulnerable. Their dividends will look less appealing as the yields on less volatile fixed-income alternatives climb. These bond proxies have become popular with yield-hungry investors, driving up their valuations, and according them an outsized presence in many portfolios. As a result, investors may be far less diversified versus their bond holdings than they realize.
Other victims of rising rates include housing-related stocks, such as homebuilders, building-materials suppliers and even home-improvement retailers, as rising rates make owning and maintaining homes more expensive. Mortgage insurers and originators could also prove at risk, though the story here is more nuanced. Rising rates clearly make buying or refinancing a home less attractive. However, if higher rates are a by-product of a strengthening economy, their impact may be offset by greater housing demand and, as important, improvements in credit quality. Finally, higher borrowing costs will put pressure on a broader set of capital purchases, such as for automobiles and equipment, which are typically financed.
Cyclicals to Rise to the Occasion
On the other side of the ledger, a rotation out of defensives would likely favor cheaper, more cyclically sensitive stocks in materials, energy and consumer discretionary industries. But positive rate sensitivity lurks in many other corners as well. Financial stocks are an obvious example. Banks typically see a nice boost in their net interest margins if long-term rates rise faster than short-term rates (as is typical in an economic recovery).
The situation for insurers is more mixed. Life insurers tend to benefit from rising rates, as they should bolster returns of their predominantly fixed-income general account investments and reduce balance-sheet-impairment risks. More subtle is the impact on their annuity portfolios. Earnings from these businesses have been under pressure over the past several years, as declining reinvestment rates made it tougher to meet the high minimum-return guarantees on these vehicles. As rates pick up, policyholders are more likely to let these contracts lapse, as they pursue higher-return alternatives.
Rising rates are trickier for property and casualty insurers and reinsurers. Though they too benefit from improved returns on their investment portfolios, history shows that this is often offset by more aggressive (re)insurance pricing as less underwriting income is required to achieve total-return hurdles. Moreover, claims losses tend to climb as the economy improves and inflation rises. However, the recent influx of third-party capital seeking the uncorrelated returns of catastrophic insurance has been depressing rates for a couple of years now. Higher returns elsewhere might stem this tide.
The economic ripple effects of rising rates will be varied and subtle, differing from industry to industry and from company to company. In our view, these times call for active investing approaches, which have the flexibility to anticipate and react to whipsawing market conditions and adjust exposures accordingly.
Chris Marx is a Senior Portfolio Manager on the Global Value Equities team at AllianceBernstein Holding LP (NYSE:AB).
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
