2. Consider the US technology sector, which generally has had a tendency to perform well, relative to the broader market, when real rates are rising. This is partly because technology companies carry little debt so they are less vulnerable to margin compression from rising rates. In addition, as I write in my Market Perspectives piece, real rates generally rise in the context of a strengthening economy, a regime favorable to cyclical companies like tech firms. The US technology sector is accessible through funds such as the iShares U.S. Technology ETF (IYW).
3. Consider Overweighting US mega caps relative to US small caps. Small companies, along with other risky assets, have been shown to generally perform best in an environment when monetary policy is very accommodative and investors are in a risk seeking mode. Historically, during these periods, small- and mid-cap companies have tended to trade at higher valuations than larger, more stable companies. But as real rates rose, small-cap valuations relative to those of large-cap firms tended to decline, as evident in an analysis of US real rates levels and small cap relative valuations from 1997 to the present using Bloomberg data as of July 15.
Today, small-cap indices are trading at a relatively expensive level versus large-cap companies. When real rates were negative, this premium was more justified. However, this premium will be harder to justify as real rates continue to rise, unless small-cap companies can generate significantly faster earnings growth. This suggests to us some compression in the valuation of small caps relative to large caps over the next couple years. It also suggests that larger firms are likely to do better in an environment of higher real-interest rates. One way to access larger US firms is through the iShares S&P 100 ETF (OEF).
To be sure, there is one major cost associated with increasing exposure to equities: Higher volatility. As always, there is no free lunch. Investors must decide just how much more risk they are comfortable taking in exchange for potentially better results if rates do continue to rise.
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.