What Do Higher Interest Rates Mean for Higher Yielding Equity Sectors?

April 20, 2018

It looks like interest rates will dominate both fixed income and equity markets in 2018. Potentially higher interest rates have not only negatively affected bond markets, but have also wreaked havoc in certain sectors of the equity markets. Particularly hard hit:

• Consumer Staples, down 7.1%;
• Telecom, down 7.0%;
• Real Estate, down 6.7%, and
• Utilities, down 4.7 %.

Predictably, these are the worst performing sectors in the S&P 500 through April 13, 2018. The S&P 500 was down 0.1% over the same period.

Given the stubbornly low interest rate environment after the Global Financial Crisis, investment firms created a plethora of high dividend indices and strategies to respond to the world’s demand for yield. Investors who were not comfortable taking a bet on long duration bonds often invested in high dividend yield strategies to capture yield premiums over the 10-year bond and S&P 500. After a few years, high yielding sectors were often among the best performers in the market. For instance, in 2014 the Telecom sector returned 29.0%, trouncing the return of every other sector and the S&P 500 index.

Dividend-oriented ETFs saw $40B in net inflows which was in stark contrast to equities which have seen outflows over the same time period. However, there have been periods of outflows, namely during the Taper Tantrum in the summer of 2013 and in December 2015 after the Fed’s first interest rate hike.

However, the interest rate outlook is very different today versus three years ago. The global economy is strong and the U.S. is embarking on an interest rate normalization process. Since year-end, the yield on the 10-year bond increased 0.4% from 2.4% to 2.8% and the S&P 500 Dividend Aristocrats index, a proxy for high yielding stocks, yields 2.5%, which is lower than the yield on bonds. As fixed income’s yield prospects have improved, the interest in bond-proxy sectors has waned and investors are starting to withdraw assets. Although outflows are not as extreme as in December 2015, the return prospects of bond-proxy sectors could be challenged further as rates continue to rise.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.