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Equity Perspectives

Investors may want to think twice before trying to position a portfolio based on a guess where rates may be headed next.

(This article is derived from Lord Abbett Insights, a quarterly shareholder publication providing market, investment, and retirement insights.)   

Interest rates have defied earnest attempts to forecast them consistently in the past (see Chart 1), and are likely to do so again in the future. The problem is that market participants often overestimate their ability to predict what lies ahead. That makes positioning a portfolio based on a projection of future interest rates inherently risky. And the lesson applies to both the fixed-income and equity side of a portfolio.

 

Chart 1. Experts Continue to Miss on Interest-Rate Forecasts
Six-month interest-rate forecast versus actual yield movement for indicated periods

Source: The Wall Street Journal Economic Forecasting Survey and the U.S. Department of the Treasury. Data represent the six-month forecast and actual yield for the 10-year U.S. Treasury bond. The Wall Street Journal surveys a group of nearly 50 economists on more than 10 major economic indicators on a monthly basis.
Data as of 06/30/2017.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or de­pict future results. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Market forecasts and projections are based on current market conditions and are subject to change without notice. A basis point is one one-hundredth of a percentage point. Past performance is not a reliable indicator or guarantee of future results.

 

The Toss of a Coin
There are volumes of published research on the reliability of interest-rate forecasts. Using J.P. Morgan data, Lord Abbett’s own empirical analysis concludes that over a 26-year period, going back to June 1991, investors failed to forecast the direction of interest rates correctly a majority of the time.

The time frames of the forecasts were of no consequence, nor were the levels of conviction. In fact, the batting average in our analysis was approximately 45–48%—no better than a coin toss.

In fairness, an investor might suggest that a 48% chance of getting it right represents a 48% chance of increasing the return on a fixed-income portfolio, for example, by reducing duration ahead of an increase in Treasury yields. But there would be added risk to the portfolio in terms of increased volatility.

Treasury-yield volatility is consistently higher than corporate-spread volatility (a measure of credit risk). That means, for example, it wouldn’t take much of an adverse move in Treasury yields to negate any benefit of assuming more credit risk in a portfolio. In other words, one would potentially be exposing the portfolio to greater performance volatility by actively betting on the near-term direction and/or magnitude of movements in interest rates.

We believe there’s a similar lesson for equity investors, especially those looking for income from dividend-paying stocks, particularly in the so-called “bond proxy” sectors, such as consumer staples, real estate, telecommunica­tion services, and utilities.

A Difficult Task
What caught our attention was a recent video, “The Case for Owning Dividend Stocks as Rates Rise.”1 Implied in that title is a belief that interest rates will move in a particular direction. But positioning a portfolio for moves in interest rates, whether up or down, is as difficult for equity-income investors as it is for their fixed-income counterparts. Rates have a habit of defying the most elaborately constructed forecasts, even during periods when central bank activity (in this case, the U.S. Federal Reserve) would suggest movement in a particular direction for U.S. Treasury securities.

That’s an important point to remember, given the frequency with which the direction of rates can shift.

In fact, according to Bloomberg, the bond-proxy group produced exceptionally strong returns relative to the broader market (as represented by the S&P 500® Index) as interest rates declined in the first half of 2016. Much of this outperformance was attributed to the group’s lower-volatility return profile and an income stream that was attractive relative to what could be found in the fixed-income market—factors that helped popularize the bond-proxy label. However, when interest rates began to rise in July 2016, the group faltered, as evidenced in its negative performance through March 13, 2017, a period in which the broader equity market posted strong returns. In fact, the bond-proxy sectors trailed the broader market by 16% over this short time period. The bond-proxy stocks continued to lag the broader market, albeit by a narrower margin, as rates resumed falling in March 2017. In short, equity-income portfolios that relied on bond-proxy sector overweights for returns were most exposed to those times when interest rates were shifting, resulting in wide swings in performance through these periods.

Fortunately, a wide range of opportunities exist for equity-income investors beyond the narrow confines of the traditional bond-proxy designation. As we noted in the July issue of Lord Abbett Insights, a look at the breakdown of dividend payers in the Russell 1000 Index by sector (as of June 30, 2017) shows that the traditional bond-proxy sectors now comprise only around 25% of the dividend universe. The sectors contributing to the broader dividend-paying universe currently are very diverse—including financials, information technology, consumer discretionary, and industrials—an excellent development for equity-income portfolios and investors who are concerned about the vulnerability of the traditional bond proxy sectors to unpredictable swings in interest rates.

The Goal of Consistent Performance Over Time
Given that empirical analysis suggests that accurately forecasting the direction or timing of interest rates is exceptionally difficult, attempting to do so is, in our view, counter to an investment objective of providing consis­tent, risk-adjusted returns over the long term.

As investors, we will always gather knowledge, opine, and be aware of potential interest-rate scenarios and risks, but we also will focus on performance drivers where we believe we have an edge—such as sector rotation and security selection—so as not to introduce unwanted volatility for our clients. (Please remember that all investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time.)

 

1”The Case for Owning Dividend Stocks as Rates Rise,” video, Barron’s, August 5, 2017.

 

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