What do rising rates have to do with stocks? One past example: the small-cap equity markets' response to a rising-rate environment, which has helped power the shift in favor of "value" – as a proxy for stocks of quality companies – over the past two years.
The logic behind rates and small-cap value: Rock-bottom interest rates since the 2008 Global Financial Crisis have made corporate borrowing less expensive, if not easier to find. As a result, companies whose profitability depends on cheap borrowing because of precarious cost structures have been able to thrive. That effect, among others, has been one of the key reasons for the strength of stocks overall since the beginning of the record-breaking bull market that started in March 2009.
But over the past two years, as the Fed hiked its target rate in December 2015, equity markets reacted by all but closing the near-term performance gap between small-cap growth and value, And since the election of Donald J. Trump in November 2016, the gap has been as wide as 8.9 percentage points in favor of small-cap value. In large-caps, the effect was smaller, but no less clear – a 3.1% performance gap in favor of value vs. growth since the election.
Taste of things to come?
Russell 2000 Growth and Russell 2000 Value Indexes, Jan 1 2015 – Feb 28 2017 and Fed Funds Target Rate (Upper bound)
Source: Bloomberg, as of Feb 28, 2017 Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The key difference: One key thing to keep in mind: when it comes to investing, value is no substitute for quality. There's a big difference between "cheap", and "cheap for a reason", as experienced portfolio managers know all too well. It takes skilled active investment management to take advantage of the difference between the two in ways not easily replicated by a more passive approach.