Interest rate expectations are shifting. What does this mean for a stock portfolio?

This week’s chart illustrates activity from the last week of September. It depicts the forward 1-month overnight index swap (OIS) curve. Think of the OIS curve as the market’s expectation for where the interest rate curve is headed. Notice that the dark blue and purple lines from the 21st and 22nd are relatively the same. The light blue line for the 28th is steeper and higher. This is a move in market expectations for higher rates.

During this period of rising expectations, the Growth segment of the US market lost significantly more than the Value segment of the market.

Broadly speaking, there are a couple of reasons for this:

 

1. Present Value of Future Cash Flows Creates Stronger Headwinds for Growth Stocks

Last week I illustrated how rising rates hurt the present value of an investment. I mentioned that, in theory, a stock’s value should be the present value of its future cash flows. As the required rate of return goes up (which it will when the interest rate goes up), the present value of the investment goes down. The timing of these future cash flows mean that a changing interest rate can have varying impacts on present value.

Investors in Growth stocks typically don’t expect an immediate cash flow in the form of dividends. In fact, Growth companies are usually spending additional capital to grow the business. That cash pull and the expectations of the stockholder being paid a larger dividend further into the future, accelerates the impact of rising rates when you discount them to the present value.

Value stocks, on the other hand, tend to pay dividends, creating a clearer cash flow discounted much sooner than Growth stocks. This lowers the negative impact of increasing rates on the present value calculation.

 

2. Interest Rate Changes Can Create Tailwind for Certain Value Stocks

Interest rate increases can be good for certain types of companies. For example, Financials are better positioned to benefit in a rising rate environment. Banks profit from increased interest rates, and brokerage houses typically see additional transaction activity during rate increases.

Financials are the largest sector in the Large Cap Value Index but a very small portion of the Large Cap Growth Index. These Financials can help drive a Value index upward when interest rate expectations rise, but they don’t provide the same buoy to a Growth index.

Before you run out and sell all the way out of Growth and pile into Value, there is a reason that the words headwind and tailwind work well for this situation. Interest rates are not the only factor driving these aspects of the market over the long-term. I believe that during this illustrated week, they were impactful enough to show the direction of the winds. But winds change. A tailwind does nothing for you if you plant your feet in the ground. A headwind can be overcome with enough additional force.

 

Stay tuned for more thoughts on this in my next blog.

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