“Our research suggests that the current environment may present opportunities for those investors who have the ability and willingness to take some active risk and be a little more targeted in their approach,” said Ian Kresnak, an investment strategist at Vanguard and a member of the Vanguard Capital Markets Model (VCMM) research team.¹

Kresnak noted that we are in an unusual market and economic environment, which is likely to mean that the Fed will raise interest rates over the coming years to levels not seen since before the global financial crisis. Although the recent events in Ukraine and uncertainty about the effects policy normalization will have on the broader economy raise the risks that rates may not rise as much as we anticipate, it is unlikely that they will stay at or below current levels due to high inflation rates.

This environment is likely to lead to rising real interest rates, which differ from nominal interest rates in that real rates are adjusted to remove the effects of inflation. The VCMM team investigated how some sub-asset classes performed during rising real rate environments and what drove performance. Given Vanguard’s expectation that the Fed may raise the nominal rate to 3%, the team focused on similar periods with relatively large rate hikes that also led to spikes in real rates.

The analysis examined a mix of economic environments during which real rate increases occurred, including during an improving economy in 1992–1994 and a period of low growth and low interest rates in 2014–2019.

“It was important to include a wide range of economic cycles to capture as many of the conditions that exist today,” Kresnak said. “This allows us to get a better understanding of how and why different sub-asset classes performed.” 

The team's research resulted in three key findings:

The chart below shows how 13 common sub-asset classes in investors’ portfolios performed over six periods when real rates rose. The sub-asset classes that outperformed on average also tended to outperform across the six periods. The same was true for those sub-asset classes that on average underperformed, as they consistently underperformed across the different environments when real rates rose.

“Although it is not a perfect relationship, there is a clear pattern that exists between rising real rates and sub-asset class performance,” Kresnak said. “When real interest rates are rising, investors tend to prefer the certainty of more immediate cash flows in their equity portfolios, which is what we typically see in high-quality value stocks, the best-performing sub-asset class during rising real rate environments.”

The VCMM team found that the relationship between rising real rates and performance is stronger with bonds than with equities, given the more fixed nature of bonds’ cash flows. “Equity cash flows are more uncertain, and performance tends to be influenced more by other factors, such as the business environment,” he said. “In general, bonds tend to be adversely affected in a rising real rate environment.”

Despite the current high inflation, it may not be advisable to overweight traditional inflation hedges such as Treasury Inflation-Protected Securities and commodities, Kresnak said. “Traditional inflation hedges have typically underperformed when real interest rates rise, because policymakers are acting with the goal of bringing down inflation, and investors generally believe they will succeed,” he said.

Rising real rates typically are associated with improving economic conditions and higher inflation. But they can also rise because of excessive monetary tightening or deflation, which causes economic conditions to contract.

The chart below compares performance in a rising real rate environment when economic conditions are contracting and when they are improving. It clearly shows a positive slope for most sub-asset classes, suggesting that relative performance is similar whether the economy is expanding or contracting, as long as real rates are rising. If economic conditions were a key driver of relative performance, we would expect the dots to be positioned along the solid diagonal line sloping downward.

The analysis revealed three notable outliers—emerging markets, commodities, and high-quality value. Vanguard research shows that valuations for emerging markets stocks are sensitive to local economic environments, which were expanding while the U.S. was beginning to slow in the runup to the global financial crisis.² The unexpected behavior of commodity returns has more to do with the short-term impact of the late-1970s oil crisis. When that period is removed from the sample, commodity returns are less responsive to changing economic conditions. Finally, high-quality value stocks tend to outperform when economic conditions are strong, because investors are less willing to pay a premium for growth when it is plentiful.

The analysis also looked at sub-asset class performance during periods of rising and falling real interest rates. The negative slope in the chart below suggests that changes in real rates are a significant factor in explaining relative performance.

Kresnak added that many sub-asset classes that stand to gain in a rising real rate environment have been out of favor for years. As real rates increase, the risks are that active investors will stick with the best active decisions of the past decade and that passive investors will fail to rebalance.

“The opportunity is that the sub-asset classes that stand to gain the most from normalizing policy are more attractively priced precisely because they underperformed in the last decade,” he said. “In that sense, both active and passive investors stand to benefit.”