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Defensive and dynamic market responses to the fed

Defensive and dynamic market responses to the fed

By: Tom Goodwin, Senior Research Director

The Federal Reserve Bank (the “Fed”) is at last moving to raise interest rates in 2016 but just how far and how fast it will go remains a matter of debate.

In a recent post, Russell Pure Style Indexes: Are value stocks due for a comeback?, we examined how Russell equity style indexes have responded to past periods of rising interest rates. As investors adjust to the inevitable rate rise, we’ve now examined another angle, studying how Russell Stability Indexes – Defensive and Dynamic—would have responded to rate hikes in the past.

The Russell Stability Index Series® sorts stocks into two groups. One group, Defensive, has relatively low return volatility, high return on assets, low earnings variability and low leverage. The other group, Dynamic, takes the other side of those characteristics. Defensive indexes can be used by investors to help them identify the lower risk, higher quality half of the market. Dynamic indexes can be used by investors to help them in identifying the relatively riskier and cyclically driven half of the market.[1]

As illustrated below, we have focused on the same four periods of tightening monetary policy over the last 30 years as we did in the earlier blog about style indexes. We chose to look at large cap and small cap separately, to see if there would have been a notable difference. Again, using averages across the four periods, we have tried to cancel out any economic or financial factors unique to these time periods.

Based on the historical/simulated application of the methodology for the relevant indexes, the chart below shows how the large cap indexes would have responded to the last four periods of rising rates (indicated by the circles in figure 1). The Russell 1000 Defensive, Russell 1000 Dynamic and “parent” Russell 1000 index all would have been adversely affected by a rate rise in the first few months. Dynamic would have dipped further than Defensive, at least initially, but then would have recovered more sharply than Defensive after a few months.

We discovered similar response patterns for the small cap indexes. As illustrated below in figure 3, while the Russell 2000 Dynamic Index typically took a significant hit in the early months following the start of a tightening period, it also snapped back sharply and recovered lost ground six months out. Defensive, by contrast, on average would have had a milder negative response and snap back, but it also experienced a marked upswing about six months out.

The table summarizes the key takeaways of our experiment. All of the indexes on average would have been negatively impacted in the first few months of a rising rate environment, and all would have fully recovered to positive territory within six months. The differences between indexes are in line with dynamic stocks being the most sensitive to cyclical short term economic conditions, while defensive stocks tend to be immune to an extent. All the indexes would have been in positive territory 12 months out, with not a lot of difference between them.

Of course, whether or not this is a useful guide can only be determined when the Fed reveals its path of higher rates.

 

[1] Feldman, B. (2012), “Stability is the Risk Dimension of Equity Style,” Russell Research

 

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