One of the more obvious features of modern investment is that different types of shares – and different types of investment styles – perform differently based on different macro-economic variables or rates regimes. Thus, common wisdom has it that in a regime where interest rates are rising, value stocks tend to outperform. The direction of interest rates (and inflation0 combines also with the absolute level of interest rates – it’s clear that low rates over long periods of time are generally good news for momentum driven styles. But are these commonly held truths still valid? Two MSCI analysts have been digging around into the numbers surrounding macro and factors and their results were out earlier this week. Abhishek Gupta and Raina Oberoi have looked at long periods of consecutive hikes and cuts in the federal funds rate, with each period lasting at least four quarters, with a change of 200 basis points (bps) or more. They then compared the federal-funds rate with the neutral rate to determine whether the current rate was above, at or below neutral. In terms of equity indices, the analysts calculated the average annualized active returns of the MSCI USA Factor indexes as proxies across the two rate regimes from December 1975 to September 2018.  The MSCI analysts are clearly looking to see how trend growth and inflation impact portfolio mix and stock style selection. Their conclusions?

“Our analysis shows that, historically, during periods when rates are neutral, the value factor has done well, while in periods of rate cuts, the minimum volatility and high dividend factors have turned in a positive performance.

The chart shows historical levels of the federal-funds rates with shaded areas for long-term interest-rate hikes and cuts. It also shows estimates of neutral rates with a 75% confidence interval around it (yellow shaded region). Whenever the federal-funds rate is within the yellow shaded region, the MSCI analysts model it as at neutral; otherwise, above or below neutral.

Source: Federal Reserve, Laubach-Williams, MSCI

For instance, the MSCI USA Equal Weighted Index outperformed the MSCI USA Index by 0.8% annually during periods of rising rates, whereas it outperformed by 2.4% during periods of falling rates.

“Overall, during periods of declining rates, all factor indexes responded positively, relative to their full-history active return and vice versa, though the magnitude of the response varied. Small-cap stocks (the low-size effect represented by MSCI USA Equal Weighted Index) that have historically had higher leverage were vulnerable to rising rates but tended to manage cash flows better when rates were falling. On the contrary, larger “quality” companies that tend to be financially healthy and have lower leverage (represented by the MSCI USA Quality Index) were less affected by rising rates.”

Income investors have gravitated to bonds over dividend-paying stocks when rates have risen. However, in falling-rate environments, the high-dividend portfolios have provided a “yield cushion” and traded at a premium. Last, low-volatility stocks have exhibited bond-like behavior when rates have declined, and value stocks have been less sensitive to rate changes.