RISING RATES HIGHLIGHT THE BENEFIT OF DIVERSIFICATION

3.10.2021

Research Brief Presented by
Cameron Dees, CFA®, Research Analyst

KEY TAKEAWAYS

Market volatility has spiked in response to rising rates and inflation concerns

Rising rates and a steepening yield curve are healthy signs of an economic recovery, provided that the rise is due to the proper drivers

The Fed remains committed to not let rising borrowing costs choke off the recovery

Allegiant’s approach to portfolio construction proves that diversification wins out

VOLATILITY TRENDING HIGHER

Volatility is not exclusively a downside concept, even though investors tend to only focus on it when it is associated with a market correction. Although nowhere near the pandemic peak, market volatility has spiked in recent weeks (Figure 1 ) in response to rising interest rates (Figure 2).

Figure 1

Figure 2


Why Are Rising Rates Such A Big Deal?

To liken financial markets to cooking, interest rates are base-level ingredients for almost every financial asset as well as a gauge for broader economic activity. Asset valuations typically move inversely to rates. When rates move higher the perceived value of financial assets move lower. However, financial assets and interest rates can move higher together if rates are rising for the right reasons.

The “right reasons” question is the biggest source of the current market volatility. Interest rates are a sum of numerous premia but the two most important are the inflation premium and the real “risk-free” rate. The real risk-free rate historically provides a proxy for expected economic growth. The inflation premium gives insight into what the market is expecting in terms of inflation.

Prior to February, the rise in rates came mostly as a result of rising inflation premiums. The good news is that the most recent spike in rates has come primarily from a rise in real yields rather than increasing inflation expectations (Figure 3).

Figure 3


Why Allegiant Preaches Diversification

Times like the present are exactly why Allegiant believes so strongly in the power of diversification. While rising rates may disproportionately hurt growth stocks with above-average valuations, rising real yields and a steepening yield curve are constructive for many cyclically oriented areas like Financials, Industrials, and Small-Caps.

This has played out since the beginning of February (Figure 4). The Allegiant team will continue to monitor the interest rate situation and lean on diversification to get through these periods of heightened volatility.

Figure 4


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