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Market View

Not all U.S. equities have performed the same when rates rise. Ignoring that simple fact could have serious repercussions for investors.

 

In Brief

  • Historically, growth stocks have outperformed value stocks in periods of rising interest rates.
  • For investors who rely on an index, or an index-hugging strategy for their growth allocation, this may be a particular concern.
  • For example, many companies in the top 20 of the Russell 1000® Growth Index are slow growth and high yielding
  • A prudent investor will want to ensure that their portfolio’s growth exposure is actually providing exposure to growth.

 

As the U.S. Federal Reserve continues to implement measured, gradual increases of its target fed funds rate, investors have been grappling with the ramifications of these steady rate hikes on their fixed-income portfolios. This is not without good reason, as the inverse correlation between bond prices and yields is a basic investment tenet and, historically, credit has tended to outperform duration as fixed-income yields rise.

However, what is less often considered by investors is the impact rising rates may have on the equity positions in their portfolios. Many investors believe that equities, at least from a broad asset-allocation level, have been a strong hedge against rising rates historically. Certainly, at a high-level, the relative outperformance of equities in periods of rising rates can be validated; in the nine periods over the past 25 years when the 10-year U.S. Treasury yield has risen by 100 basis points (bps) or more, U.S. equities (as represented by the Russell 3000® Index) on average have returned nearly 17%, according to FactSet.  

But not all U.S. equities have performed the same when rates rise. Ignoring that simple fact could have serious repercussions for investors.

In particular, historically there has been a notable divergence between growth and value during periods of rising rates. According to Morningstar, as shown in Chart 1, during the nine most recent periods of a more than 100 bps rise in the 10-year U.S. Treasury yield, domestic growth stocks have outperformed domestic value stocks two-thirds of the time, averaging an annualized return of more than 20% and outperforming value stocks by more than 7% in each of the periods on average. This is a substantial performance differential, roughly equal to the long-term average annual return of the S&P 500® Index.   

 

Chart 1. Historically, There Has Been a Notable Divergence Between Growth and Value Stocks During Periods of Rising Rates
Returns (%) of growth and value stocks during nine periods when 10-year U.S. Treasury yields rose more than 100 basis points

Source: Morningstar Direct.  Growth stocks as represented by the Russell 3000® Growth Index.  Value stocks as represented by the Russell 3000® Value Index. Past performance is not a reliable indicator or a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

For investors, we believe the implication of this divergence in equity returns should be clear: growth stocks should be a key part of a diversified asset-allocation mix during periods of rising interest rates.

For this reason, a prudent investor will want to ensure that their portfolio’s growth exposure is actually providing exposure to growth. This is a particular concern for investors who rely on an index, or an index-hugging strategy for their growth allocation.

A prolonged period of accommodative monetary policy that kept interest rates ultra-low following the global financial crisis led to some notable distortions across the capital markets, including fevered demand for dividend-paying stocks that in many cases yielded substantially more than a 10-year U.S. Treasury. With surging price-earnings multiples, these stocks began to find themselves inside major growth indexes despite having little or no fundamental growth at all. Even as markets have begun to normalize in the years following the end of quantitative easing, many of these slow-growth high-yielding stocks still can be found at the top of these growth indexes, which may come as an unfortunate surprise for investors seeking growth specifically as a hedge against rising interest rates.

 

Table 1. Many Companies in the Top 20 of the Russell 1000® Growth Index are Slow Growth and High Yielding
Top 20 companies in the Russell 1000 Growth Index by market capitalization, as of September 30, 2018

Source: FactSet. *Historical 3-Year Sales Growth data as of 9/30/2018. **Alphabet, Inc. Class A and Class C shareholdings have been combined. Price-to-Earnings FY1 ratio shown is an average of the two share classes.
The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. The information shown is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of investments.

 

To be sure, both value and growth strategies can play an important part in equity portfolios, as each possesses characteristics that make them potentially well-positioned for varying market and economic environments. For investors seeking growth as a way to capitalize on the current rising-rate environment, utilizing a strategy that is focused on identifying stocks exhibiting true fundamental growth may be a preferable option that is more accurately aligned with their desired outcome.

 

IMPORTANT INFORMATION

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Historically speaking, growth and value investments tend to react differently during the economic cycle. Since value stocks are often cyclical in nature, they may benefit from the increased spending that usually occurs during an economic expansion. Growth stocks may also perform well during an expansion, but they may also be out of favor during market downturns, when investors pay more attention to price ratios. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Technology and Internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market. No investing strategy can overcome all market volatility or guarantee future results.

References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a guarantee or a reliable indicator of future results.

Glossary of Terms

One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument.

A Dividend yield refers to a stock's annual dividend payments to shareholders, expressed as a percentage of the stock's current price. 

The price/earnings ratio (often shortened to the P/E ratio) is the ratio of a company's stock price to the  company's earnings per share.

Quantitative easing, also known as large-scale asset purchases, is an expansionary monetary policy whereby a central bank buys predetermined amounts of government bonds or other financial assets in order to stimulate the economy and increase liquidity.

The Russell 1000® Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.

The Russell 3000® Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.

The Russell 3000® Growth Index measures the performance of those Russell 3000 Index companies with higher price-to-book ratios and higher forecasted growth values.

The Russell 3000® Value Index measures the performance of those Russell 3000 Index companies with lower price-to-book ratios and lower forecasted growth values.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged and are not available for direct investment.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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