Predicting equity returns with rising rates

The impact of higher rates on equity returns is a concern for investors and to some extent an unknown. But by applying the concept a threshold correlation, as done with bond portfolios with a duration targeting framework, it is possible to better understand the complex interactions between equity returns and interest rate movements.

The latest portfolio strategy research paper by Morgan Stanley Research’s Martin Leibowitz and Anthony Bova, shows that while theoretical, uses duration targeting for equities and the concept of a threshold correlation to provide some guidance in assessing the impact of rising rates on long-term equity returns.

It finds there is a threshold correlation between equities and interest rates that can be applied to maintain an initial expected require return across a range of interest rate paths.

For a 10-year horizon the threshold correlation was found to be -0.3, so a correlation greater than that leads to improved 10-year returns for positive drift rates and to a deteriorating 10puyear returns for negative rate drifts.

Over shorter horizons, such as five years, the threshold correlation is -0.15

The study focuses on two simulations: rate-driven increases in expected equity return; and realised return drags from adverse equity/rate correlations. It uses a simulation approach with two interconnected random walks for interest rates and equity returns.

The detailed paper Portfolio Strategy: A Theoretical Model of Equity / Bond Correlation under Rising Rates, can be accessed in the Morgan Stanley Investment Management Journal InvMgtJournal_2014v4i1