Which investment style and which regions would benefit from renewed growth in interest rates?

You can see here that cyclical equity sectors perform best when the US 10-year rate starts rising. But what is the impact of a rise in long-term interest rates on the different regions and styles that investors can choose to include in their portfolio?

Since the early 1980s, both US and European long-term interest rates have fallen sharply. In fact, things went so far that we had negative interest rates for a while. However, more and more economists are forecasting an increase in long-term interest rates in the next few years. They like to use the 10-year rate as an example. For equity investors, the trend of 10-year rates – and especially the most popular US one – is an important parameter when managing a diversified portfolio.

Rising interest rates determine which sectors will do better or worse on the stock market floor, but they also create regional differences and differences in style. In a recent report from JPMorgan, we saw the following chart, which shows the regions and styles that do relatively better in times of rising interest rates.

Japan and the euro zone are the winners

In regional terms, Japan and the euro zone tend to do better when 10-year interest rates rise. On the other end of the scale, emerging countries and the US are the countries that would likely perform less well. That makes sense, because Japan and the euro zone mainly have industrial stocks in their primary stock market indices (Nikkei 225, Stoxx Europe 600, Euro Stoxx 50). So it suits them just fine when interest rates rise. By contrast, the US and emerging countries have mainly technology shares in their benchmark indices (S&P 500, Nasdaq and MSCI Emerging Markets). The technology sector suffers under rising interest rates because it demands a high level of investment, which clearly becomes more expensive with higher interest rates.

More S than L

As far as investment styles are concerned, we note that small caps (shares with a market capitalisation of 500 million to 2 billion dollars) fare better than large caps (shares with a market capitalisation of over 10 billion dollars). We derive the market capitalisation of a listed company by multiplying the number of issued shares by the stock market price.

Again, this is because small caps are mainly found in the industrial and cyclical sectors. In other words, the sectors that benefit from an expansionary global economy. And global economic growth often involves rising interest rates. At present, it is relatively easy to invest in small caps, because there are various trackers, such as European or US small caps indices.

Figure 1: Correlation of regions and styles with the US ten-year rate

Source: JPMorgan

Conclusion

The likelihood of a rise in long-term interest rates will increase over the next few years. As we know that the US 10-year rate sets the trend for global rates, it is not a bad idea to review your equity portfolio with this in mind. The figure suggests that the choice of euro zone and Japanese shares, and some extra weighting in small cap shares might well be the right decisions.

Geert Van Herck Chief Strategist KEYPRIVATE