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Weekly Investment Commentary: Rising rates: What to know, what to do
Bottom line up top
- January’s market tantrum: Last month played out like Newton’s third law of physics with a twist: for every feared Fed action, there was an equal and opposite overreaction. The 10-year Treasury yield spiked 27 bps, and U.S. large cap growth lagged U.S. large cap value by 7%, its worst relative showing since March 2001. The direction of the moves wasn’t surprising, but the magnitude was, even for the most hawkish of Fed tightening scenarios.
- The number of rate hikes this year isn’t the most important question. We’re focused on the prospects for continued global reopening and solid corporate earnings growth, both of which should drive positive, if moderate, investment returns. There’s precedent for such resilience: Global equities posted gains in all eight Fed tightening cycles over the past 40 years, with an average annualized return of 11.3%. Even core U.S. bonds were positive during those same eight cycles.
- “Long duration bad, short duration good?” It’s not that simple. A shorter duration bias makes sense in a rising rate environment, but we wouldn’t completely abandon investment grade taxable and tax-exempt fixed income as portfolio diversifiers. And for equities, we prefer a cyclical tilt while also looking for select highquality growth stocks, especially U.S. software names that are trading at bargain prices.
Rising rates and portfolio construction
- Investors are more worried about duration today than in, say, December 2020 when the Fed was still patient. But the pickup in yields since then has led to a more attractive risk/reward profile in the belly of the curve (the threeto five-year duration segment).
- For predominantly fixed income portfolios, allocations in this range (but closer to three years) appear well-suited to the goal of minimizing drawdown due to higher rates.
- For investors using fixed income to cushion other parts of their portfolios, we think duration closer to four to five years may better absorb any unexpected growth shocks. As shown in Figure 1, a duration longer than five years could potentially produce negative returns with a 50 bps rate increase over the next year.
“We’re seeing the best value in the belly of the yield curve.”
Positioning for rising rates by asset class
- We’re leaning toward credit in fixed income. Broadly syndicated U.S. loans remain a top choice, given their favorable yield per unit of duration. In the last three Fed hiking cycles, loans outperformed U.S. core bonds by 283 bps, on average — significantly more than the 81 bps margin for high yield. Municipals should benefit from credit improvement as stimulus dollars support state and local budgets. We expect high yield munis to continue their year-to-date outperformance given the credit environment and the higher yields they offer. We also think private credit may offer impressive yield with less volatility.
- Further increases in the 10-year Treasury yield will likely be driven by higher real rates, not inflation expectations. For that reason, now is not the time to overweight inflation hedges like TIPS or gold.
- In equities, we’re emphasizing U.S. large cap value and U.S. small caps, which look poised to outperform as rates rise. We also see compelling opportunities in certain beaten-down growth stocks. Additionally, we like select non-U.S. developed markets. Despite their weak historical correlation to changes in real yields, some of these markets should benefit from attractive valuations and economic reopening.
- In real estate, the market has not fully appreciated how much the pandemic has reset the cycle for certain industries. We see sector valuation opportunities in areas like housing and storage, for example. On a geographic basis, non-U.S. real estate could outperform due to comparatively delayed reopenings. Longer term, higher rates may hurt asset values, but that will largely depend on the pace and primary driver of rate increases.
About Nuveen’s Global Investment Committee
Nuveen’s Global Investment Committee (GIC) brings together the most senior investors from across our platform of core and specialist capabilities, including all public and private markets.
Regular meetings of the GIC lead to published outlooks that offer:
- macro and asset class views that gain consensus among our investors
- insights from thematic “deep dive” discussions by the GIC and guest experts (markets, risk, geopolitics, demographics, etc.)
- guidance on how to turn our insights into action via regular commentary and communications
Endnotes
Sources
All market data from Bloomberg, Morningstar and FactSet
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