The Federal Reserve typically hikes interest rates to obviate an overheating economy during the later stages of an economic cycle, typically foreshadowing the eventual end of a bull market. Nevertheless, the equities market and stock exchange traded funds may still have more room to run before that end.
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“As rising rates have affected U.S. equities recently, there is still hope for the asset class. Equities have gained significantly in periods of rising rates,” Jodie Gunzberg, Managing Director, head of U.S. equities at S&P Dow Jones Indices, said in a note.
The S&P 500 Index, along with related funds including the SPDR S&P 500 ETF (NYSEARCA: SPY), iShares Core S&P 500 ETF (NYSEARCA: IVV) and Vanguard 500 Index (NYSEARCA: VOO), have increased 2.4% so far this year and gained 18.5% over the past year.
While there are some concerned about a slowdown in equities as rates rise, the stock markets have historically plodded ahead during periods monetary tightening. Since 1971, the S&P 500 has increased about 20% on average in rising rate periods, according to S&P Dow Jones Indices data. Furthermore, the S&P 500 has generated positive returns eight of nine times since 1971 and even jumped nearly 40% twice, with less than a 4% loss for its worst rising rate period.
During periods of accelerating growth and inflation, such as what we are experiencing now, rising rates could translate into appreciating assets.
“Since the rising rates are happening in a profitable economy with strong growth forecasts and increasing dividend payouts (with an extra boost from the income tax reduction,) the variables impacting the equity duration are more positive for stocks,” Gunzberg said.
Looking at historical data, on average for every 100 basis point increase, every single sector, size and style gained. In comparing the various categories, small-caps led gains with 7.3% on average for every 100 basis point rate increase, followed by mid-caps that gained 5.9% and large-caps that gained 2.5%.
“The growth acceleration that cancels the negative equity duration is the same growth that propels small-caps so much, putting them in a leading spot to rise with interest rates – especially since monetary policy is not too tight so that rising interest rates don’t hinder the borrowing by small companies too much,” Gunzberg said.
Investors interested in gaining exposure to the small-cap segment have a number of options available For instance, the iShares Core S&P Small-Cap ETF (NYSEArca:IJR) follows the S&P SmallCap 600 Index, Vanguard Small Cap ETF (NYSEArca:VB) tracks the the CRSP US Small Cap Index, iShares Russell 2000 ETF (NYSEArca:IWM) reflects the benchmark Russell 2000 Index, and the SPDR S&P 600 Small Cap ETF (NYSEARCA:SLY) is based off the S&P 600 SmallCap Index.
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