This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.
Since the Great Financial Crisis in 2008, many investors have come to favor a low volatility approach to the equity markets. But while low volatility strategies are generally designed to address the effects of market risk, there’s another risk that today’s investors are also anticipating — the risk of rising interest rates. The combination of rising volatility and rising interest rates has historically weighed on stock prices.1 Below, I take a look at the prospects for rising rates and volatility and discuss one strategy that aims to address both.
Higher rates on the horizon?
The US labor market is tightening, as evidenced by the latest Job Openings and Labor Turnover Survey (JOLTS), conducted by the US Bureau of Labor Statistics. The JOLTS report has become a favorite of Federal Reserve (Fed) Chair Janet Yellen, and assesses unmet demand for labor in the US. The chart below indicates that year-over-year (Y/Y) hourly earnings growth is still below recession levels, but has risen steadily since the first quarter of 2013. Note that the ratio of private job openings to hiring is at a cycle high.
The JOLTS data can be indicative of continued wage growth. Already, we are seeing hard evidence from major retailers—many of which have voluntarily raised their minimum wages since the start of the year. The Fed’s Beige Book has also noted modest upward pressure on wages and prices, as well as employers’ difficulty in attracting high-skill workers, while the most recent personal income data shows wage and salary disbursement rising a healthy 4.5% y/y.2
Improved economic growth, a tightening labor market and low energy prices all augur for an end to the Fed’s accommodative monetary policy and the potential for rising interest rates. The Fed put an end to quantitative easing last fall, and the Federal Open Markets Committee has signaled a desire to slowly start normalizing interest rates. The Taylor rule, a monetary policy rule used by some Fed watchers, indicates that the federal funds rate should be 2.50%, compared to the current target of 0.25%.2
Global market uncertainty
Concurrent with interest rate risk, investors face a great deal of market uncertainty in the second quarter of 2015 and beyond. Eurozone officials are bracing for a possible Greek default on debts owed to the International Monetary Fund and European Central Bank, and there is significant uncertainty over Greece’s status within the eurozone.
Although European leaders have argued that the economic union can withstand a Greek exit, such a scenario would leave the European Central Bank with billions of dollars in Greek debt. It would also likely sow doubts about the future of the eurozone and have the potential to roil the world’s financial markets.
Outside of Europe, markets are facing the potential for a correction in Chinese equities, and the strong US dollar is weighing on US exports and earnings growth.