By Komson Silapachai, Sage Advisory

A rising tide lifts all boats, but do rising rates lift all assets? The yield on 10-year Treasury notes rose above 3% last week – the highest it’s been since 2014 – and the yield on two-year Treasury notes hasn’t been this high since the 2008 financial crisis.

When interest rates rise, many investors fear a negative effect on the economy. A combination of rising inflation, increased bond supply, and the Federal Reserve’s tightening policy have caused the recent increase in yields. In what ways could higher rates lead to lower growth, and more importantly, how should ETF investors position themselves?

Higher Rates – A Risk Factor for The Economy?

Here are how higher interest rates could negatively affect growth:

  1. Rising interest expense for the corporate sector. Companies that finance their operations with debt incur interest expense, which drives down profit margins. According to JPMorgan, a 100 basis point increase in bond yields typically results in a 1.5% drag on S&P 500 earnings (not including financial services companies, which would see a benefit to earnings). Until recently, rates had remained relatively low since the financial crisis, and the lower interest expense has been a huge driver of corporate profit margins. Increasing rates would in theory reverse that trend. However, the impact of higher rates is mitigated by the fact that corporate debt has generally been issued at longer maturities (an average of 10-plus years) and at fixed rates, so rising interest expense is not an immediate concern at the macro level.
  2. Lower consumer demand due to rising interest expense for households. Higher interest expense decreases the level of disposable income, which should lower consumption and as a result, reduce GDP growth. This impact is somewhat mitigated as households have deleveraged over the past decade, and household debt service ratios remain at multi-decade lows.

How Higher Rates Negatively Affect Equities:

  1. Reduced value of future earnings. In its purest form, equity prices reflect the discounted future earnings of a company. Higher interest rates increase the discount rate, thereby lowering the company’s present value. If rising interest rates aren’t offset with higher top-line growth, either through higher prices (inflation) or higher volume (more demand), then equities could be in trouble as market participants price in a higher discount rate.
  2. Declining attractiveness of equities as earnings yields decline. When earnings yields significantly exceed bond yields, it becomes cheaper for companies to finance projects, M&A, and share repurchase programs. When the difference between earnings yields and bond yields is zero or negative, the equity-market boosting behaviors could slow or stop. With increasing bond yields and high stock valuations, that gap has been decreasing, but it still remains at above-average levels. So while it’s not a red flag yet, if the gap continues to narrow, it could drive stock prices lower.

An ETF Toolkit in a Rising Rate Environment

A rising rate environment does not signal immediate danger for the economy, since the private sector has deleveraged a great deal since the crisis and the Fed has been very methodical in communicating future rate hikes. However, markets are forward-looking and investors could start to price in the effect of higher interest rates on financial assets before they actually materialize.

It’s important for investors to have options in order to prepare for that scenario. Within equities, XLF (Financial Select Sector SPDR Fund) provides exposure to a sector that stands to outperform as financial services companies, such as banks and insurance companies, have historically shown higher profitability during periods of higher interest rates. Within fixed income, exposure to inflation-linked bonds through TIP (iShares TIPS Bond ETF) would shield bond investors from rising interest rates, due to rising inflation expectations and/or rising commodity prices. The Senior Loan Market provides investors with exposure to corporate debt without the corresponding interest rate risk; we prefer the actively managed version through SRLN (SPDR Blackstone / GSO Senior Loan ETF).

This article was written by Komson Silapachai, CFA, Vice President, Research & Portfolio Strategy at Sage Advisory, a participant in the ETF Strategist Channel.