Wh at i f I n t e r e s t R at e s R i s e ?
A Special Commentary Series
asset allocation & rising rates
A fundamental decision for any investor is making the
proper asset allocation: how much to place in stocks,
bonds, and cash to fulfill one’s investment objective.
Bonds are generally selected to fill the role that income
and/or price stability plays in a diversified portfolio.
Today, with interest rates plumbing historic lows, it’s
important to recognize the risks presented by the
potential for higher interest rates. Bond investors face a
two-pronged dilemma—where can better yields be found,
and how to temper the risk of higher interest rates.
High-quality bonds, especially U.S. Treasury securities,
have benefitted from the “flight to safety” trade, as well
as weak economic conditions. As macroeconomic risks
recede and Washington politicians strive to place the
federal budget on a sustainable path, there’s a risk that
yields on these high quality bonds will creep higher.
The 10-year Treasury bond was approaching a yield of
4.0% in early 2010 before Europe’s crisis struck but is
now being offered with a yield just around 2%. One
mechanism by which rates could rise is that economic
conditions improve and fiscal fears subside. The bond
market could then begin to price inflation expectations,
which would ultimately be responsible for a sustainable
rise in interest rates.
Because inflation has been low since the financial crisis,
the question becomes: what asset classes work in a low and
rising inflation rate environment? There have been seven
cases of low and rising inflation since 1972. Chart A shows
major asset class returns for these historical examples, with
equities and commodities as the big winners.
While historical examples provide guideposts for the
future, there are major differences in the current
investing environment. Bond yields are at record lows,
while equities are just awakening from a 12-year slumber.
As the economic environment continues to normalize,
those investors who have the flexibility to do so are likely
to invest in equities, over bonds and cash equivalents.
Relative valuation also supports an eventual move out
of bonds and into stocks. Chart B shows the historical
stock market price-to-earnings ratio (P/E ratio) and
an equivalent P/E ratio for the 10-year Treasury, which
is simply the bond price divided by the yearly coupon
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Chart A: Asset class returns during periods of low and rising inflation
Percent
20%
20
17%
15
10
6%
5
3%
0
Bonds
Equities
Cash
Commodities
(Source: Janney ISG, BLS, Barclays Capital, Robert Shiller, Federal Reserve, Strategas/Ibbotson,
Standard & Poor’s, FactSet, J.P. Morgan Asset Management)
Chart B: S&P 500 P/E and equivalent 10-Year Treasury P/E
Price Earnings Levels
80
S&P 500 P/E
60
10-Yr Treasury P/E
40
20
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
(Source: Janney ISG, Bloomberg)
Chart C: Stock dividends higher than bond yields
for first time in decades
Percent
10
8
10-Year Treasury yield minus S&P 500 dividend yield
6
4
2
0
S&P 500 yields are higher than those offered
by the 10-Year U.S Treasury Note
–2
1981
1984
1987
1990
(Source: Janney ISG, Bloomberg)
1993
1996
1999
2002
2005
2008
2012
payment. Note that this equivalent bond P/E has spiked
to more than 50 compared to a stock market P/E
that has drifted down to about 14 today. Also, Chart C
shows that equity dividend yields are competitive with
current bond yields for the first time in many decades,
and suggests that equities are a competitive choice for
income as well as the potential to outperform in a rising
interest rate environment.
Meanwhile, economic fundamentals should continue to
support rising equity prices. Housing and autos continue
to recover from the Great Recession while plenty of
pent-up demand still exists. Labor markets continue to
heal with private payrolls up for the 36th straight month
in February. The U.S. consumer has finished the hardest
part of the de-leveraging process, and household net
worth is back to pre-crisis levels. Corporate profits will
continue to benefit from this improving economic
backdrop, and their expected increase should be
followed by a commensurate lift in share prices.
Washington continues to make progress toward a
sustainable long-term budget, Europe has taken many
measures to solve its crisis, and China appears to have
steadied its growth rate at a high but sustainable level.
This has removed major systemic risk for equities.
Valuations, therefore, should improve driving stock prices
higher as the market prices in a lower risk premium.
Dividend-paying stocks have little competition for
income-seeking investors and offer attractive means of
purchasing power protection. Companies in the S&P
500 Index are expected to pay a record $300 billion in
dividends in 2013. Corporations remain flush with cash,
and dividend payouts will continue to benefit from this.
Bond prices would come under pressure in a rising
interest rate environment, but corporate and municipal
bonds will benefit from an improving economy and
continued low defaults. Moreover, corporates and
municipals pay a higher interest rate in the meantime
than otherwise similar government bonds. Therefore,
within the fixed income market we prefer these bonds
to government issues.
Commodities will benefit from increased demand as
global economic growth improves and have historically
provided an inflation hedge.
Real Estate Investment Trusts, or REITs, have
performed well as an alternative to low fixed income
yields and generally respond favorably during a rising
rate environment.
Chart D: Investment Allocation for a Rising Interest Rate Environment
Domestic Stocks
Capitalization
Large capitalization stocks are most attractive—favor dividend-payers.
Underweight bond proxy high-yielding sectors—Utilities, Telecom, and Pharmaceuticals.
Sectors
Overweight growth-sensitive sectors—Technology, Financials, Energy, and Materials.
Commodities
Energy
Energy will benefit from a growing global economy.
Metals
Favor industrial metals over precious as economy improves and risk recedes.
Real Estate
Commercial
Low-cap rates and modest yields suggest only marginal value.
Residential
An improving economy and confidence will continue to benefit housing.
Bonds
Treasuries
Government bonds are unappealing in a rising rate environment.
Corporate Bonds
Will benefit from improving economic conditions—favor short durations.
High Yield
Low default rates will help return. Stick with shorter durations.
Municipal
Yield to taxable counterparts is beneficial to tax-free debt.
Low Correlation Alternatives
Market Neutral
Rising yields should lead to more appealing absolute returns.
Long/Short
Should benefit as market correlations decline with a lower risk premium.
Managed Futures
Should do well as falling correlations give way to better detected pricing trends.
This report is for informational purposes only and in no event should it be construed as a solicitation or offer to purchase or sell a security. The information presented
herein is taken from sources believed to be reliable, but not guaranteed by Janney as to accuracy or completeness. Any issue named or rates mentioned are used
for illustrative purposes only, and may not represent the specific features or securities available at a given time. For investment advice specific to your individual
situation, or for additional information on this or other topics, please contact your Janney Financial Consultant and/or your tax or legal advisor.
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