Factors to watch in a rising rate environment
Author: Mark Stacey
May 18, 2018
Momentum stocks have benefited from the past few years of unprecedented low volatility and have been a leading contributor of returns in many factor-driven investment strategies over that time. But now that interest rates are on the rise and volatility is back, other style factors such as value, quality and size look poised to provide a greater share of gains going forward.
This isn’t to say these three factors have performed badly of late. In 2017, they each returned greater than 20%, according to MSCI data. Instead, it’s more about the potential of some factors to outperform others in different periods of a market cycle.
A decade of factor returns
MSCI as of December 31st, 2017. MSCI index methodology resources available at www.msci.com. MSCI World Momentum Index denoted as Momentum; MSCI World Equal Weighted denoted as Size; MSCI World Enhanced Value Index denoted as Value; MSCI World Sector Neutral Quality Index denoted as Quality; MSCI World Minimum Volatility Index denoted as Volatility. One cannot invest directly in an index. Index returns are for illustrative purposes and do not represent the performance of actual accounts or reflect management fees, transaction costs or expenses. Source: Morningstar Direct as of December 31, 2017.
Value, for instance, has been somewhat neglected by investors who have been more willing to pay a premium for growth stocks in the low interest rate environment of the past decade. As rates rise, however, and the discount rate on earnings moves higher, these same investors are likely to forego premium valuations in favour of stocks that are less expensive.
High quality companies that have strong balance sheets with stable earnings and low debt levels should benefit from rising rates as well. A more normalized credit cycle will be less forgiving, however, to highly levered companies who can no longer depend on near zero interest rates to bolster profitability.
There’s also a growing expectation that the size factor will do relatively well in this changing rate environment as small capitalization stocks reassert their historical outperformance over larger cap names. This relationship has been flipped on its head at times during the long-running bull market because investors have been more inclined to buy up the market’s biggest companies and keep a low risk profile.
All things considered, investors can expect some changes in terms of those factors that will help drive performance over the next few years. This should prompt periodic portfolio adjustments, but doesn’t mean loading up wholesale on one factor over others. A disciplined multi-factor approach that continually assesses the interplay between factors remains the best option to pursue.
Mark Stacey* is a senior vice president, head of portfolio management & co-chief investment officer at AGFIQ.