Declining Interest Rates Have Historically Signaled Positive Relative Performance for Global Low Volatility

Capital markets are completing the transition from an environment that has featured quantitative easing, low interest rates and low inflation to one in which Treasury bond yields have reached levels not seen in 20 years. So this may be the time to set expectations for how global low-volatility strategies may perform in a declining rate environment. The market expects the US federal funds target rate to begin declining in Q1 2024 from the current level of greater than 5% to land below 4% by 2025.

We looked at the path of interest rates since 1990 and identified periods of increasing and decreasing rates based on US Federal Reserve action regarding the target federal funds rate. As shown in Exhibit 2, shifts in policy have historically corresponded with the direction of the US 10-year yield.

How have low-volatility stocks behaved in recent declining rate environments?

Exhibit 3 below compares the rolling 24-month performance for the lowest-volatility quintiles (“Q1 + Q2”) to the highest-volatility quintiles (“Q4 + Q5”) of stocks within the MSCI ACWI and it demonstrates the tendency, since 2004, of lower-volatility stocks to outperform as rates decline (darker shaded periods).  

Exhibit 4 shows us that despite the relative strength of low-volatility stocks during 2022, high volatility has sharply outperformed since the latter half of 2020.

Why has lower volatility outperformed during declining rate environments?

Cyclical sectors such as retailing, autos, housing, and materials tend to experience relative weakness after rates reach their cyclical peaks and economic growth slows. Comparing rolling 24-month performance, history suggests that companies with more cyclical exposure tend to underperform during periods of declining rates. This was the case from 2008 to 2009, from 2012 to 2013, from 2015 to 2016 and from 2019 to 2020. During periods of rising rates from 2004 to 2023, cyclical sectors outperformed defensives. 

Conclusion

Our analysis was conducted to address how low-volatility stocks may perform considering the market consensus rate assumptions, which currently anticipate rates cuts, and a declining rate environment for 2024. In this environment, recent cycles suggest that low-volatility stocks have typically outperformed higher-volatility stocks and going forward may provide diversification to portfolios with exposure to higher-volatility and cyclical stocks. 

Index data source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or fi nancial products. This report is not approved, reviewed or produced by MSCI.

The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice. No forecasts can be guaranteed. Past performance is no guarantee of future results.