Implications of Rising Rates for Asset Allocation

11 March 2022

7 min read

Caglasu Altunkopru| Head of Macro Strategy—Multi-Asset Solutions

Just as the world started to emerge from two years of heightened uncertainty and disruption during the COVID-19 pandemic, it faces another global crisis—this time geopolitical—with Russia’s invasion of Ukraine. Although these two shocks seem disparate, they share one common theme: an inflationary impact on the global economy.

Before war broke out in Europe, central banks had been widely expected to remove monetary accommodation during 2022. The COVID-19-induced recession and subsequent recovery have been the sharpest in the modern era, and with tighter labor markets and elevated inflation, policymakers started signaling more urgency to raise rates.

Complications from Conflict in Europe

The Ukraine conflict and resulting economic sanctions have quickly escalated well beyond early expectations. Because Russia and Ukraine account for a significant share of global energy and agricultural commodity exports, by early March the Bloomberg Commodity Index had risen more than 30% from 2020 year-end levels and oil prices 60%.

Economic links between Russia and the European Union (EU) and US are being severed, with the Russian economy likely heading into a deep recession. Meanwhile, a growing number of EU and US corporations are shuttering their Russia operations.

The spike in commodity prices and the stresses of effectively disconnecting the world's eleventh largest economy (3% of global gross domestic product) from much of the developed world complicates central banks’ plans to reduce policy accommodation. The commodity supply shock will boost inflation and dent real consumer spending power, while the sharp impairment in the value of Russian assets could create financial risks that may not have fully played out yet.

Uncertainty About the Ultimate Geopolitical Impact

The economic recovery has been strong so far, and inflation concerns are elevated, so the Fed appears on track to start raising rates this month (after the date of this publication), even though near-term rate-hike expectations have declined. Europe’s policymakers have room to be more patient with rate hikes, given the possible greater hit to economic growth from the Ukraine conflict and somewhat lower starting inflation than in the US. The European Central Bank, however, did announce plans to accelerate its tapering, which was a surprise.

There’s still a lot of uncertainty about the eventual economic fallout from the war, both near-term and long-term. The scope of sanctions and potential mitigation measures are still evolving. The duration of sanctions is unclear, although these measures have historically been long-lived. To the extent that sanctions aren’t global, at least some portion of Russian flows are likely to find their way to other destinations.

More broadly, economic relations between the US, Europe, China and Russia a year from now could be very different from those prevailing over the past decade. Given these risks, central banks may be compelled to follow a nuanced, data-driven approach as long as geopolitical risks persist—but this approach will likely be challenged by higher-for-longer inflation.

Strong Growth Backdrop Pre-Ukraine War…

A key question for asset allocation is whether equity performance—a key growth driver in multi-asset portfolios—can withstand a period of rising interest rates. Historically, rate hikes have tended to coincide with strong economic backdrops, with equities and other risk assets performing well during these episodes, on average.

In other words, rising rates didn’t necessarily derail economic growth nor equity returns (Display). For the six months following initial rate hikes, equity performance trailed cash in only three of 10 historical episodes. Performance was similarly robust during hiking cycles, with below-average returns aligning with recessions and steep hiking paths.

Rising Rates Haven’t Necessarily Derailed Returns

Developed Market Equity Performance During Central Bank Rate Hike Cycles

Equity performance in historical cycles of central bank rate hikes

Past performance does not guarantee future results.
As of February 28, 2022
Recessions start on November 1973 and January 1980
Source: Bloomberg, Bureau of Economic Analysis and AllianceBernstein (AB)

The current economic backdrop is among the more robust compared to prior hike cycles. Real household consumption has withstood the withdrawal of substantial fiscal support as well as above average inflation. Service activity, curtailed by the omicron variant early this year, has rebounded, and the labor market seems to have powered through the omicron wave. Businesses continue to restock below-average inventories and boost capital investment.

…but Higher-for-Longer Inflation Could Complicate a Soft Landing

However, the disruption of trade with Russia and Ukraine will likely challenge the economic growth backdrop. The two countries account for a significant share of global export volumes for key commodities including oil, natural gas, coal, wheat, corn, fertilizer and nickel. Some of these markets, such as oil, were already seeing tight supply conditions before the war; as the invasion unfolded, commodities surged in anticipation of the disruption.

The backdrop of high inflation, a commodity shock and looming Fed rate hikes has the raised the specter of the stagflationary 1970s, featuring two oil crises, steep rate hikes, boom/bust cycles and subpar equity returns. Both the 1973 and 1979 oil crises featured sharp rate hikes against a weakening growth backdrop in order to slow inflation.

While higher-for-longer-inflation is likely to dent real economic growth prospects, we expect central banks to adopt more nuanced stances than the 1970s experience. Weaker linkages between wages and inflation, a smaller share of energy spent in total consumption (Display) and the lack of balance-sheet excesses in the private sector support a more patient approach.

Energy Spending Has Been a Smaller Share of Personal Consumption

Oil Price vs. Energy Share of Personal Consumption Expenditures (PCE)

Past performance does not guarantee future results.
Through February 28, 2022
Oil price represents the West Texas Intermediate oil price in constant 1970 dollars, adjusted based on the Consumer Price Index (CPI)
Source: Bloomberg, Bureau of Economic Analysis and AllianceBernstein (AB)

However, already-high inflation increases risks because policymakers feel pressure to respond to persistently high inflation. Expectations could also become unanchored, which would necessitate a stronger policy response. As a result, we think a modest underweight exposure to equities is prudent as investors continue to monitor long-term inflation expectations and supply-side developments.

Will Fixed-Income Continue to Diversify?

For sovereign bond allocations, could an environment with low expected returns and the potential for markets to price in further rate hikes translate into a diminished diversification benefit?

Sovereign bond exposure is commonly thought of as a defensive strategy, but bonds haven’t always been a good diversifier to equity exposure. In fact, equity/bond correlations were mostly positive for much of the period from 1976 through 2000 (Display). Even in the 1960s, when inflation was muted, stock/bond correlations were more muted but not as negative as they’ve been over the past two decades.

Fixed-Income Diversification Has Evolved over Time

Equity-Bond Correlation vs. Fed Funds Rate

A comparison of the stock-bond correlation and the fed funds rate over time

Past performance does not guarantee future results.
Through January 31, 2022
Source: Bloomberg, Federal Reserve and AllianceBernstein (AB)

In our view, the post-2000 diversification power of bonds supported a relatively scarce supply of safe assets globally, as a product of the global "savings glut," increased financialization, low and stable inflation and more transparent, predictable central bank policy. On a long-term basis, we expect these trends to continue. Governments have been winding down COVID-19 fiscal-stimulus programs, reducing supply even after accounting for the end of quantitative-easing programs. As a result, safe assets are likely to remain scarce.

On the other hand, real, or inflation-adjusted, yields remain low, so sovereign bonds are still expensive. Given the higher upside risk to inflation from the Ukraine war, and with rate hikes on the way, the diversifying potential for sovereign bonds has been—and is likely to remain—below normal. Even post-2000, when bonds were diversifying to equities, the repricing of short-term bond yields meant that correlations were less negative than average during hike cycles.

We expect correlations to revert as markets gain clarity on the longer-term impacts of the war, as inflation starts to show signs of peaking and as central-bank policy paths become better established. Another possible path is one where the negative impact from inflation is strong enough to trigger a recession, resulting in a pause or even reversal of rate hikes. In fact, market pricing has started to call for cuts in late 2023.

Implications for Portfolio Construction

Given the below-average expected returns from bonds and diminished diversification benefit in the near-term, we believe it makes sense to be tactically underweight to direct duration exposure. That means opportunistically seeking other sources of portfolio protection against equity downturns, such as option strategies—though these are costly at current volatility levels, so that needs to be a consideration.

Bond proxies, such as high-dividend and low-volatility strategies, or sector exposure to utilities, real estate or consumer staples, might be other options for asset allocations, because valuations for these segments of the market are attractive. We expect the re-rating of these exposures to continue, such that they can outperform their duration exposure.

Despite a recent upward reaction to the Ukraine invasion, yield spreads on credit investments remain historically low, which suggests an above-average sensitivity to rising inflation and higher interest rates. This is particularly true for investment-grade credit, where duration is a larger risk component than in high yield credit. As a result, we think neutral exposure on high-yield credit is sensible. Another avenue could be to moderate the level of equity risk in asset allocation until financial markets have fully digested and priced in the likely path of interest-rate hikes.

To the extent that investors are modestly underweight several portfolio building blocks, excess funds can be held in tactical cash positions. And of course, because portfolio construction is necessarily dynamic and interactive, investors will need to keep a close eye on the growth and inflation regime and its implications for cross-asset correlations.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Author

Caglasu Altunkopru

Caglasu Altunkopru is Head of Macro Strategy in the Multi-Asset Solutions Group at AB. She was previously a sell-side analyst at AB, covering equity portfolio strategy for six years. Altunkopru joined the firm in 2005, covering the European Household and Personal Care sector, and her team was ranked among the top three in Institutional Investor and Extel surveys. Prior to joining AB, she worked as a management consultant with The Boston Consulting Group, Bain & Co. and McKinsey, serving clients in the consumer goods and financial services sectors. Altunkopru holds a BS in mathematics from the Massachusetts Institute of Technology and an MBA from Harvard Business School. Location: New York

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