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.

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.

Learn more about XRLV.

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.

Read more blogs by Nick Kalivas.

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.