To combat rising inflation, in April 2022, the Federal Reserve began raising the Fed funds rate from its target of 0%-0.25% to 5.25-5.50%, pushing one-month Treasury bills (interest rate benchmark risk free) at 5.50%.

While all crystal balls are clouded when it comes to future interest rates, it appears that rates will be significantly higher (at least for a while) than they were from October 2008 to March 2022 (when fed funds rate operated with a zero interest rate policy, called ZIRP).

While equity and bond markets expect rates to fall, they are likely to remain well above the ZIRP rate regime we experienced during the period October 2008 – March 2022. And this is likely to be the case across the globe. For example, markets EXPECT the federal funds rate is on average 320 basis points (bps) higher over the next 10 years than it was roughly 14 years before the Federal Reserve began raising interest rates in March 2022. The equivalent gap is 300 bps for the eurozone and 380 bps for United Kingdom. What, if any, are the implications for asset allocation? Does a higher cash rate increase, impair, or have no significant effect on total asset returns?

AQR's Thomas Maloney attempted to answer these questions in his paper “Honey, Fed Cuts Equity Premium: Asset Allocation in a Higher Rate World”, published in April 2024 ABoUT e Journal of Portfolio Management. To test the sensitivity of returns, he used three different methods to determine the lowest and highest rate regimes:

• Complete sample categorization: He divided the sample into above and below average rates. While this method was simple and intuitive, it tended to result in several extended episodes of each environment and, therefore, a small number of independent observations.

• Rotating categorization (next window): He compared each observation to the subsequent five-year period to break the streak and identify more episodes of higher and lower rates.

• Rotating categorization (window in the center): He compared each observation to the five-year period centered on it. The concentrated method was used because, unlike a trailing window, it was not biased toward periods of rate increases—and Maloney wanted to test sensitivity to levels, not changes.

Maloney's data set covered the period 1926-2023 and US equity returns, US Treasury bond returns and US corporate loan returns. Here is a summary of its main findings:

All three asset classes delivered positive premiums in both the high and low regimes over a range of horizons. However, premiums were not constant. Risk premia were smaller when initial cash rates were higher for all three asset classes and across all horizons—and most dramatically for stocks.

Bonds earned somewhat higher total returns in higher rate regimes, albeit with smaller risk premiums.

While real returns on equity were lower in the higher rate regime, real returns on Treasuries and cash were significantly higher.

Private, illiquid assets (real estate and private equity) showed similar patterns to equities (positive but lower nominal and real returns in higher rate regimes), while liquid alternatives—which tend to hold significantly the former – yielded similar excess returns in higher and lower value environments.

If all expected asset returns moved in parallel with cash rates, higher cash rates would make investing easier. But history leads us to expect different responses from different asset classes, with cash plus liquid alternatives gaining a relative advantage. Lower stock returns in higher rate regimes occurred despite their lower valuations during such periods. Equity returns were also lower in higher rate regimes, although when initial interest rates were high they were more likely to fall than to rise further—on average, starting from a higher rate regime high, the Treasury bond rate fell 27 bps over the next period. 12 months and 73 bps over the next 36 months. Starting from a lower rate regime, the corresponding average changes were increases of 29 bps and 63 bps respectively.

One explanation for the lower real stock returns in the higher interest rate regimes (despite the lower valuations and greater likelihood that rates will fall) is that over the period 1926–2023, the annual increase in real returns for per share (EPS) was 11% when starting from a low interest rate but only 1% when starting from a high interest rate (arithmetic means). The geometric mean was 5.8% and -1.1% respectively. “Intuitively, it is low interest rates that stimulate demand and facilitate financing and business expansion.”

Maloney then considered whether some investments offer more resilient premiums in the face of higher interest rates. To answer this, he examined a shorter and broader data set, starting in 1990, so he could add real estate, private equity, and liquid alternatives—selecting market-neutral strategies. equity and trend-following, as represented by hedge fund indexes, because both have exhibited near-zero equity betas over the long term, and both tend to hold large cash holdings. He found that they were able to generate comparable SURPLUS returns to both environments. Thus, their average total returns were significantly higher in the higher rate regimes.

His findings led Maloney to conclude: “In a world of higher rates than investors have seen in many years, diversification away from stocks may be especially valuable.” He added that during the zero rate regime of the 2010s, many investors with return hurdles to contend with were “forced” to significantly increase their allocation to risky assets. Similarly, with empirical evidence that higher rate regimes have been associated with lower premiums not only for equities but also for real estate and private equity, liquid alternatives gain a relative advantage over other return-seeking assets. in higher rate regimes, delivering historically plus cash returns. He added: “Equity stocks and illiquid alternatives tend to underperform when cash rates are higher. Bonds have done a better job of passing the cash rate on to investors and liquid alternatives have done the best of all.”

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While stocks and bonds have on average provided positive returns in both higher and lower interest rate regimes, their risk premiums have tended to be lower in higher rate regimes, with implications for expected future returns and asset allocation decisions.

Liquid alternatives (which today have significantly lower expense ratios than 20 years ago, when they were generally only available as hedge funds with typical 2/20 fee structures) have provided a relative advantage over other assets with risk in higher rate regimes. In addition, they can provide significant diversification benefits, as they can add unique sources of low-correlated risk to traditional stock and bond portfolios.

In addition to daily liquid, market-neutral funds and trend-following funds, two relatively new alternatives can be considered. The first is reinsurance, which also offers a unique source of risk (hurricanes and earthquakes generally do not affect equity and bond markets, and markets carry in those assets do not cause hurricanes or earthquakes) and benefits from higher rate regimes , as reinsurance. funds hold their collateral in the form of treasury bills. Reinsurance funds can be either daily liquid (as can be the case with catastrophe bond funds) or semi-liquid (in the case of interval funds, which provide quarterly liquidity, usually a minimum of 5% per quarter). The second is private, senior, secured debt backed by private equity firms, available in semi-liquid interval funds. Unlike corporate bonds, these loans are all variable rate. Thus, their yields benefit from rising interest rates.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest, Enrich your future.