Below is a chart reflecting the Economic Policy Uncertainty Index constructed by Baker, Bloom & Davis. The index takes into account the frequency of news articles on policy uncertainty, as well as dispersion in economic forecasts. The index has come down from its recession highs, but has been on a steady climb since last November. Interestingly, low volatility stocks have historically outperformed during spikes in this economic uncertainty index. This is illustrated by the red line, which shows the performance of the lowest volatility quintile of the S&P 500 Index relative to the overall S&P 500 Index. The higher the line, the higher the relative outperformance of the lowest volatility quintile of the S&P 500 Index.
A two-factor approach
We believe the current risks in the global market landscape support the need for continued risk mitigation and low volatility investing — but investors also need to keep an eye on interest rate risk. Historically, the combination of rising volatility and interest rates has had an adverse effect on equity prices. Since 1990, during periods when the CBOE VIX Index (an indicator of market volatility) rose 75% or more and the 10-year Treasury yield also increased, the price of the S&P 500 Index declined 80% of the time by an annualized average of 30.4%.3
In light of this, investors may want to consider the PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (XRLV), which provides investors with a two-factor solution to rising interest rates and increased market turbulence. This exchange-traded fund tracks an index that selects the 100 stocks with the lowest volatility from the 400 stocks in the S&P 500 that have shown the greatest return history during periods of rising interest rates. The holdings are then weighted inversely to their volatility.
Source 1: Dow Jones S&P and Invesco PowerShares as of Dec. 31, 2014. Results based on 11 occurrences between 1990 and 2014, including the years 1990/1991, 1993/1994, 1994, 1995/1996, 1998, 1999, 2005, 2006, 2008, 2013/2014. There were two occurrences in 1998.
Source 2: Bloomberg LP as of April 21, 2015
Source 3: Bloomberg LP as of Feb. 18, 2015. Period of study encompassed Jan. 1, 1990, to Feb. 18, 2015. The five periods were December 1992 to April 1994, June 1990 to August 1990, January 2006 to June 2006, December 1995 to July 1996 and May 2008 to July 2008.
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Important information
The Federal Reserve Beige Book is a summary of anecdotal information on current economic conditions in each of the Fed’s 12 districts.
The Economic Policy Uncertainty Index is compiled by Scott Baker, Nick Bloom and Steven Davis. It is constructed from three types of underlying components. One component quantifies newspaper coverage of policy-related economic uncertainty. A second component reflects the number of federal tax code provisions set to expire in future years. The third component uses disagreement among economic forecasters as a proxy for uncertainty.