In May 2013, then-Federal Reserve (Fed) Chairman Ben Bernanke warned that economic strength could require a slowdown in the pace of the central bank’s asset purchases. The market reaction, since dubbed the “taper tantrum,” was a sharp, temporary selloff in bonds and a sudden wariness among investors about the effects of a potential change in interest rate policy. The episode raised an important question: What do rising rates mean for investment portfolios?
 
Nearly a decade has passed since investors have witnessed a rising rate environment. Even then, the last go-round was short-lived. In reality, investors have not grappled with persistent interest rate gains for more than 30 years.
 
Amid what many market watchers suspect could be the twilight of a prolonged secular bond bull market, the issue now is whether little-noticed but important relationships between asset prices and interest rates may come to the fore.
 
How should investors broach the subject of rising interest rates? Examining the history of asset class performance during periods of rate gains is one useful starting point. Insights from the historical record include the following:
 
• Shifts in rate regimes have often moved with speed—surprising both the market and the Fed;
 
• Historically, global equity prices have often rallied in both the run-up to policy rate-hike cycles and in the year following the onset of rate increases—with the health of the economy a key consideration.
 
• In the U.S., large-capitalization equities have frequently staged a short-term dip as investors assess the change in environment, but these episodes have frequently proven to be buying opportunities; and
 
• History shows that diversified bond portfolios have often turned positive within a period of a few years even amid rising interest rates.

The Element of Surprise: Rates Historically Have Gained Faster Than Expected

History affords several examples of both investors and policy makers failing to anticipate the speed of change once a new rate cycle has begun.
 
The 1994 rise in the Federal funds target rate overshot the Fed’s projections by more than two percentage points within four months of the initial rate increase. Subsequent periods of increased Federal funds rates in 1999 and 2004 also saw early projections outpaced, albeit by smaller margins.
 
Notwithstanding 2014’s scenario of a drop in rates, markets historically have shown themselves capable of outflanking the prevailing opinion of investors.
 
Global Equities Historically Have Advanced Before and After Rate Increases

While there is no perfect historical precedent for the Fed’s extraordinary post-crisis monetary policy, there is precedent of equity market performance amid rising interest rates. Equities have advanced in the majority of recent historical examples.
 
In the last 32 policy-rate hike cycles globally, local equity markets gained a median 12% in the 12 months leading up to the start of the new rate cycle. A similar pattern emerges from the same sample of global cycles after the onset of a new rate regime, with the median equity market rising 10% in the year following the initial hike.
 
The trend over one and two-year periods in the U.S. recently has been similar. The S&P 500 Index (Index) gained an average 17% during the 12-month periods leading to the prior three rising-rate regimes beginning in 1994, 1999 and 2004. Then, after the Fed raised rates, the Index in the above cases added another 6%, on average, in the subsequent year.
 
While the prospect of rising rates after a period of extraordinary monetary policy may give some investors pause, the generally held theory behind rising rates’ and rising stocks’ coexistence is quite simple: benign economic environments. If the broader economy is expanding, this thinking goes, higher rates may simply reflect the rising pace of economic activity. Economic expansion has historically been an underpinning of corporate earnings growth, which historically has often been identified as a driver of long-term stock returns.
 
In the U.S., Short-Term Equity Market Dips Have Been Commonplace

In the U.S., periods of equity-market turbulence immediately following interest rate increases have been quite common—as have equity market recoveries in the subsequent months.
 
In the immediate wake of the decision to increase the Federal funds rate in 1994, for instance, the S&P 500 Index dropped 4.8% over three months (February through May). In the three months following the 1999 rate increase, the Index lost 1.3% (July through October). The loss for 2004 (June through September) was 0.6%. These temporary selloffs proved to be potential buying opportunities, as subsequent performance was generally positive.
 
How Long-Term Bond Allocations Have Fared Amid Rising Rates

Investors’ rising-rate concern often centers on fixed income, where bond math shows that rising rates mean falling prices. But math also suggests that bond maturity matters. The ability of a diversified fixed income portfolio to roll into newer, higher-yielding bonds historically has helped blunt some of the impact of rising rates.
 
In the 1994 rate cycle, for instance, the Barclays U.S. Aggregate Bond Index fell 2.2% one year after the Federal Reserve raised interest rates. The decline did not persist indefinitely. The same index posted an 18% gain in the three years following the rate hike. In 1999 and 2004, the index also gained over one- and three-year post-rate hike time frames.

What Does Divergence Mean for the Possibility of Interest Rate Change?
 
As the experience of interest-rate declines in 2014 showed, anticipation of higher rates is no guarantee that rate increases will actually occur. Several factors could delay the possibility of rising rates, among them continued low inflation or the uneven state of global economic growth.

Many investors believe the newest such challenge is the divergence of central bank policy between the U.S. and most other major world economies.
 
As the Fed moves toward tightening, the Bank of Japan and European Central Bank (ECB), among others, have moved toward more accommodative policies. The divergence in developed countries points to a question ahead: Do diverging growth and policy mute economic and market volatility and thus “diversify” global growth, or do these factors force more aggressive action by central banks focused on their own domestic mandates?
 
From a policy perspective, we believe that continued divergence in growth may create challenges for the major central banks. For example, if the Fed is trying to slow domestic demand by tightening policy at the same time the ECB is trying to stimulate domestic demand by easing policy, each central bank may find that they need to move more aggressively. If that is the case, government bond yields in the U.S. and Europe potentially may diverge from each other by a larger degree than they would in a synchronized economic and policy cycle.

Fed Fear and Its Discontents

While the persistence of the current low interest rate environment underscores the challenges faced by any would-be predictor of rate increases, the historical record may offer some consolation for those who watch the subject with concern. Most significantly, equity market performance both in the U.S. and globally has tended in most cases to be positive when the tide of interest rates turns. While bond portfolios understandably remain a focal point for rate considerations, long-term allocations historically have, as we showed above, weathered rising rates to a greater degree than the climate of public debate today may suggest.   
 
 
Miner is global head of Strategic Advisory Solutions within Goldman Sachs Asset Management, a unit of Goldman Sachs.