These Stocks Do Well When Rates Rise

Domestic equities continue reminding investors that rising interest rates do not have to be punitive for equities. Last week, the Federal Reserve raised rates for the third time this year. The S&P 500 surged Monday, extending its year-to-date gain to over 9 percent.

That statistic indicates broad-based strength for equities amid this year's Fed tightening, but there are pockets of superior performances.

What Happened

As has been widely documented, small caps are outperforming their large-cap rivals this year. The iShares Russell 2000 ETF IWM, the largest exchange traded fund dedicated to domestic small caps, entered Monday with a year-to-date gain of 11.51 percent, well ahead of the S&P 500 and the Russell 1000 Index.

Historical data suggest this year's small-cap surge is not unusual when rates rise. Actually, smaller stocks often perform well as the Fed tightens. Looking at annualized performances of various benchmarks during Fed tightening cycles from 1993 through 2016, the small-cap Russell 2000 Index delivered annualized returns of around 22 percent, according to FTSE Russell data.

Why It's Important

Small-cap stocks performing well as rates climb indicate investors have some appetite for risk during tightening cycles. Growth stocks and the related ETFs confirm as much. The iShares Russell 1000 Growth ETF IWF entered Monday with a year-to-date gain of almost 17 percent.

As is the case with smaller stocks, it's not unusual to see growth names outperform as rates rise. Looking at Fed tightening cycles from 1993 through 2016, the Russell 1000 Growth Index, IWF's underlying index, delivered average annualized returns of 20 percent, according to FTSE Russell data.

IWF holds over 540 stocks and allocates about 60 percent of its weight to the technology and consumer discretionary sectors, groups that are usually hallmarks of growth funds.

What's Next

“Not surprisingly, economically sensitive equity asset classes like small caps have fared best, with the Russell 2000 Index generating a healthy 22.2% annualized return while the Russell 1000 Growth Index has also chalked up an impressive 20.1% annualized return,” said FTSE Russell Managing Director Alec Young in a note out Monday.

“Not surprisingly, bonds have not fared as well during periods of rising rates with the 10-year Treasury note losing an annualized 5.8% and investment grade corporate bonds gaining only slightly. However, given their significant exposure to the health of corporate credit, which tends to improve as the economy expands, corporate bonds have fared well posting 15% gains”

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