Potential portfolio impacts of a rising rate or inflationary environment — domestic equity
February 1, 2013
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D. Tysen Nutt Jr.
Senior Vice President, Senior Portfolio Manager,
Team Leader — Large-Cap Value Equity
We believe we’re nicely positioned if inflation revives and interest rates finally
rise because we’re overweight energy and underweight financials and utilities.
Of course, much will depend on the details. If interest rates and inflation
increase quickly and by a lot, all sectors could be affected and potentially
hurt quite badly. But if a normalization of rates happens gradually — which is
what the Federal Reserve is certainly attempting to engineer — we believe the
market could come through fine, notwithstanding some valuation compression
and sentiment deterioration.
Even within those sectors that overall might be hurt by elevated inflationary
pressures or rising interest rates — financials, for example — there could be
pockets of strength. Banks could actually benefit from a higher rate structure
because it would improve their net interest margins, which have been suffering
as of late. Insurance companies also could gain because they would finally
squeeze some yield out of their fixed income portfolios. The main casualties
of higher rates and inflation would be in the utility and consumer discretionary
spaces, which are areas in which we currently maintain significantly
Christopher S. Beck, CFA
Senior Vice President, Chief Investment Officer —
Small-Cap Value / Mid-Cap Value Equity
Don’t forget that the Fed has made it clear that it will not even contemplate
raising benchmark interest rates until unemployment drops to 6.5%, which is
still one full percentage point below the current level. Now, that may not seem
like much, but with the real gross domestic product (a measure of all goods
and services a country produces) continuing to exhibit modest growth of
1% – 3%, any significant progress on the labor front is expected to take time.
And from an equity standpoint, the conditions that would cause the Fed to
tighten policy would be good for corporate profits, because it would mean that
economic growth is turning higher and the consumer is in better shape.
It is also important to note that many companies have locked in favorable
financing terms for years to come, even if rates were to rise sooner and by
more than is likely. The Fed has made transparency a major goal, and it has
telegraphed every major move. There is no doubt in my mind that when the time
comes to begin nudging rates higher, members of the Federal Open Market
Committee (FOMC) will provide ample notice. No observers of the market
should pick up the newspaper and get blindsided by Fed action, in our opinion.
As a result, we feel that our portfolio has the potential to perform well due to the
economic sensitivity of the overall portfolio, as long as rates rise gradually and
the Fed does indeed act to prevent significant inflation.
Francis X. Morris
Senior Vice President, Chief Investment Officer — Core Equity
Under the most likely scenario, which, in our opinion, is a gradual and modest
increase in rates and inflation, we believe small-cap stocks have the potential
to perform very well. Historically, the “sweet spot” for small-caps is real
economic growth of around 2.5% to 3.0%. This level of real gross domestic
product growth has historically correlated with small-cap returns of close to
20%. (Source: Bloomberg.)
The U.S. economy is not there yet in terms of economic growth, but it is
gradually improving, with housing being the most recent positive data point.
In terms of inflation, a little more inflation would provide the type of pricing
power that businesses need, in our opinion. All of this assumes that rates and
inflation are rising for the “right” reasons, which would be improvements in
Kevin J. Brown
Vice President, Senior Investment Specialist — Focus Growth Equity
We have no way of knowing with any degree of certainty when rates or
inflation will perk up. I do believe, though, that we’re going to get meaningfully
higher inflation at some point down the road. The only question is when it
may start to percolate, which is beyond our ability to forecast, and frankly
not our core competency. That said, I believe that the companies we hold in
the portfolios we manage have certain characteristics that have historically
performed well in a rising-rate or higher-rate environment.
We tend to avoid companies that have heavy capital expenditure funding
needs or that maintain high degrees of leverage. Flexibility in a company’s capital allocation structure could be a very powerful aspect during a higher inflation
environment, and that is one of the characteristics that we look for
in a business. It is also important to note that we currently have a little more
exposure to commodity and hard-asset plays than normal, and those positions
also could provide the portfolio with a nice hedge if inflation were to increase.
In addition, the ability to pass along pricing to customers is a key advantage
for companies in an inflationary environment. We believe that the companies in
our portfolio generally have great competitive positions and therefore are able
to pass along pricing better than their competition. Charging higher prices
while keeping costs constant (or taking advantage of flexible cost structures,
per the earlier point) enables companies to grow profitability even faster than
The views expressed in each outlook represent the Manager’s assessment of the market environment as of January 2013, and should not be
considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to
change without notice and may not reflect the Manager’s current views. The views expressed in each outlook are general in nature and do not relate
to a particular mutual fund.
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