The prospect for and ramifications of rising interest rates have surfaced time and again in recent years. Whether and when the Fed will raise rates next is anyone’s guess. But as we’ve noted before, the correlation between higher interest rates and equity declines has grown tenuous in recent history. Since 1991, the S&P 500 has risen roughly twice as often as it declined. In 124 (of a total 307) months the 10-Year Treasury Yield increased; in those months, the S&P 500 declined only 27% of the time. Though conventional wisdom is that stocks decline when rates rise, for the last 25 years, things haven’t been very conventional.
This is critical in understanding the prospects for defensive strategy indices. These indices, as the name suggests, are designed to attenuate the market’s volatility. When times are good, they won’t participate fully in the market’s performance, but they provide some protection in falling markets. They’ve also been very popular since the financial crisis in 2008.
What would be the impact of a rate rise on these strategies? The yield/performance matrix below shows the performance of the S&P 500 and the differential returns of several defensive strategies in various combinations of interest rate and market environments. Consistently, defensive strategies outperformed in down markets and underperformed in up markets. This relationship holds regardless of whether interest rates were up, down or static. Defensive equity strategies are much more dependent on the direction of the equity market than the direction of the bond market.