In a note to investors, State Street Global Advisors senior portfolio manager Toby Warburton said high yielding equities had benefited from central banks’ efforts to suppress interest rates in a post-global financial crisis world.
“This has led investors away from traditional sources of income such as bonds and into higher yielding equities,” Mr Warburton said.
“However as the argument goes, the inflow of money into these securities has led to increased valuations, crowding and reduced volatility.”
Policy normalisation is therefore likely to result in a sell off of interest rate-sensitive stocks in favour of financials and “more cyclical names”, Mr Warburton explained.
An increase in the interest rate and bond yields would cause the expected value of these stocks to decrease, Mr Warburton said, and investors increasingly allocate in to other assets as higher yielding equities become less attractive.
“To us, these reasons do not really seem to justify the relative underperformance of interest rate sensitive names. Company fundamentals will barely change with a rise in bond yields – although at the margin, an increase in borrowing rates reduces after-interest profits,” Mr Warburton added.
This thinking may prove accurate in the short-term, Mr Warburton said, as volatility and price pressure on rate-sensitive stocks is likely to increase as investors worry about interest rates, but investors should maintain a “balanced portfolio, including some stocks with interest rate sensitivity, some that benefit from increasing rates, and an exposure to both cyclical and defensive names”.
“A question we should all ask ourselves is whether we are willing to go with the crowd and therefore accept more expensive, more volatile, lower quality stocks at a time of macro-uncertainty and when the International Monetary Fund is still revising down its global growth forecasts,” he said.
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