The potential impact of rising rates on investment returns is currently an important consideration for many investors. Here we will address that question from a factor perspective, using indices published by Morgan Stanley as a guide.
Against the background of a global economy and supply chains still recovering from the COVID-19 pandemic, Russia’s invasion of Ukraine caused an additional supply shock: the price of crude oil climbed as high as $130/bbl shortly after the invasion, in tandem with escalating sanctions on Russia, and this run-up in commodity prices exacerbated existing inflationary pressures. To fight inflation, the U.S. Federal Reserve increased its benchmark rate by half a percentage point at its May meeting, the largest rate move since 2000. This has weighed on investor sentiment and put pressure on growth-heavy segments of the market, such as technology, which have benefitted from record low interest rates due to the long duration of their projected earnings. The S&P 500 Index was down nearly 17% this year, as of May 18, as the yield of the 10-year U.S. Treasury touched a three-year high above 3%.
We think that the experience since the fourth quarter of 2021 drops hints about how the current inflationary environment could impact equity risk premia. Using Morgan Stanley factor indices, the following graphs show the evolution of risk premia during this period.
Starting in the fourth quarter of 2021, when the 10-year U.S. Treasury yield began to rise, long-value positions significantly outperformed short-value positions overall. This is consistent with history, as value has been the best performer in rising-rate environments, based on MSCI data from December 1975 to September 2018.1 The period since the fourth quarter of 2021 also began with very stretched valuations in growth stocks.
Figure 1. Value Outperforming
Source: Bloomberg. Indices used: Morgan Stanley U.S. Value Long Index; Morgan Stanley U.S. Value Short Index.
High-quality companies rallied into the end of the year, but the spread between long- and short-quality closed in 2022, resulting in roughly equal performance overall. Historically, the quality factor has been resilient in rising-rate environments for two reasons: quality companies tend to have lower leverage, which means less sensitivity to rising rates through their liabilities; and because current profitability is an important marker of quality companies, their earnings projections tend to exhibit relatively short duration. The fact that this has yet to play out in the current environment suggests that we may see some improved performance from the quality factor. We also note that there is variability in the precise definition of quality, and we are already seeing positive performance from stocks that our internal models would categorize as quality.
Figure 2. A False Start From Quality?
Source: Bloomberg. Indices used: Morgan Stanley U.S. Quality Long Index; Morgan Stanley U.S. Quality Short Index.
Low-volatility stocks have been positive performers since the fourth quarter of 2021. This is not consistent with the long-term history of bond-like behavior with a tendency to underperform in a rising-rate environment. We believe this factor performed better than expected in the current environment because rising rates are coinciding with a sell-off in unprofitable technology names and “meme stocks,” which are both on the high-volatility side of the spread. There is also a beta effect, since high-volatility stocks tend to have higher beta, and higher-beta stocks have been impacted severely as the market has sold off this year. We think the relative performance of the low-volatility factor may weaken as these mispricings are resolved.
Figure 3. Unexpected Resilience From Low-Volatility Stocks
Source: Bloomberg. Indices used: Morgan Stanley U.S. High Volatility Index; Morgan Stanley U.S. Low Volatility Index.
Momentum has outperformed over the past two quarters, in line with the historical performance in rising-rate environments since 1975.2 The spread narrowed at the end of 2021, but widened in the first quarter of this year, reflecting a composition shift: the momentum factor rotated into value-oriented names and away from growth stocks as value began to outperform.
Figure 4. Momentum Outperforms, Shifting From Growth to Value Stocks
Source: Bloomberg. Indices used: Morgan Stanley U.S. Momentum Long Index; Morgan Stanley U.S. Momentum Short Index.
Overall, we see factor spreads providing positive returns in the current environment. This is particularly useful considering that stocks and bonds are selling off in tandem, creating a challenge for traditional, long-only 60/40 portfolio construction.
On an individual factor basis, our outlook is for value and momentum to continue to perform well and for quality to improve its performance, but we see a risk of a potential drop-off in outperformance from the low-volatility factor. In practice, we are pleased that long/short factor investing has helped many of our clients to outperform in such a challenging environment.