Positioning Equity Portfolios for When Rates Rise

October 2017 Positioning Equity Portfolios for When Rates Rise The current equity bull market is now more than eight years old and has survived several calls for its demise. So far, it has weathered economic weakness, deflation fears, earnings slowdowns, a collapse in oil prices, wild currency swings, a range of geopolitical risks and valuation worries. Another persistent concern has often been associated with corrections or the onset of bear markets: Federal Reserve rate hikes and rising bond yields. The interest rate environment has been volatile (to say the least), but rates have been rising unevenly over the past year, and we expect that trend will persist. While this will likely contribute to market volatility, it shouldn t spell the end of the equity bull market. It may, however, affect the way that investors access opportunities in U.S. equity markets. Bob Doll, CFA Senior Portfolio Manager, Chief Equity Strategist, Nuveen Asset Management Saira Malik, CFA Head of Global Equity Portfolio Management, TIAA Investments Jim Boothe, CFA Chief Investment Officer, Portfolio Manager, Santa Barbara Asset Management SHOULD INVESTORS EXPECT RATES TO RISE? Since the end of the Great Recession, it has been widely expected that improving economic growth would lead to an increase in interest rates. But that hasn t happened or at least not consistently. This is partially due to a global environment of low (and even negative) bond yields that have suppressed rates in the United States. And risk aversion has generally remained high among investors, prompting several flights to quality. Most recently, for example, concerns over hurricane-related economic damage drove Treasury yields to new 2017 lows before they subsequently rebounded. We expect the interest rate outlook to remain complicated and anticipate additional periods of short-term rate declines. But we also believe economic growth should continue growing modestly, which should put upward pressure on yields. While the current economic cycle is old in calendar terms, that doesn t mean it s coming to an end. Actuarial tables make sense for predicting human lifespans but are useless for predicting economic cycles. We don t see the excesses that would indicate the end of the current cycle such as an inverted yield curve, rising credit spreads or rapidly rising inflation, all of which can occur before an expansion ends. 1

Exhibit 1: The Bull Market in Bonds May Have Ended 20% 15% U.S. 10-year Treasury Yield Federal Funds Rate Target Yield 10% 5% 0% 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015 Data source: Bloomberg, L.P. Monthly data from March 1971 August 2017. Past performance is no guarantee of future results. Yet, it is fair to ask: If people have been calling for a rate increase for eight years and it hasn t happened yet, what s different this time? To answer, we would disagree with the premise of that question. Rates have been falling on and off for years, until the 10-year Treasury reached a low of 1.37% in July 2016. We believe rates are now in an environment of rising unevenly. We will no doubt see ongoing drops in yields such as those that occurred recently, but if U.S. and global growth continues to improve, we should see a longer-term trend of rising rates. A LOOK AT HISTORY: INTEREST RATE INCREASES AND EQUITY MARKETS If interest rates are likely to increase, is that a negative for equity markets? Investors typically fear rising rates and think they are bad for equities, but this actually hasn t been the case. It is tough to pinpoint exactly when rising rates periods begin. In the present cycle, it can be argued that we have been in such an environment since the Federal Reserve ended its quantitative easing program, or when rates bottomed in 2016. But for purposes of historical comparison, we can analyze how equities performed after the first Fed rate hike in different tightening cycles. Consider the past six rate hike cycles going back to the early 1980s. Using time periods of 250 trading days (roughly equivalent to one year), we found that while pockets of weakness surrounded rate hikes, equities generally weathered the storm. In most cases, equities performed well prior to times when rates rose, struggled or declined slightly after the onset of rate hikes, and then recovered and continued solid performance. The black line in Exhibit 2 represents the average performance of the S&P 500 Index during these cycles. We have also seen periods of heightened volatility when the Fed embarked on tightening cycles. In particular, a period of consolidation often accompanied the start of rate increases. In the 250 days before the first rate hike and the 500 days after, stock prices trended higher but experienced a modest selloff. The data is different for each of the six time periods, but on average, equities have experienced a peak-totrough decline of roughly 10%. This development is known among traders as three steps and a stumble, an anecdotal trend pointing to market declines after a third Fed rate move higher. So far, the current cycle has more or less followed this historical trend. Since the first rate hike in December 2015 (the blue line in Exhibit 2), stock prices experienced some pullbacks but managed to grind higher. 2

Exhibit 2: Equities Tend to Survive Rate Increases S&P 500 Index Returns During Rate Hike Cycles 150 Average of Previous Six Cycles S&P 500 Index Returns 120 90 Current Cycle, Beginning 12/16/15 60-250 -200-150 -100-50 0 50 100 150 200 250 300 350 400 450 500 Trading Days Data source: FactSet and Bloomberg, L.P. Past performance is no guarantee of future results. Rising rates periods are based on the dates of initial Federal Reserve rate hikes (5/2/1983, 12/16/1986, 3/29/1988, 2/4/1994, 6/30/1999 and 6/30/2004). S&P 500 Index returns are indexed to 100 starting at 250 trading days before the first rate hike. Different indices and economic periods will produce different results. It is not possible to invest directly in an index. IT MATTERS WHY RATES RISE History is a good starting point for considering how equities might respond to rising interest rates, but we also must look closely at today s markets. Interest rates can rise for many reasons and those reasons can affect how equity markets perform. For example, if the U.S. were in the midst of an inflation scare, as in the 1970s, interest rates would rise while equity prices fell. Conversely, if interest rates are rising due to improving economic growth, that would probably be good for stock prices. As a result, we sometimes see positive correlations between rising rates and higher equity prices, while at other times we see negative correlations, as shown in Exhibit 3. For the most part, we believe the current backdrop should lead to a positive correlation. In addition, we think U.S. stocks should benefit from the interest rate starting point in this cycle. This current cycle represents the first time in history that the Fed is raising rates from such a low level. And at the same time, bond yields are much lower than during other rate increase cycles. Exhibit 3: Rising Rates Have Been Both Good and Bad for Stock Prices 5-year Rolling Correlation, 10-year U.S. Treasury Yield & S&P 500 Index 0.75 Raising rates a good sign for stocks 0.50 0.25 0.00-0.25-0.50-0.75 Raising rates a bad sign for stocks 1930 1940 1950 1960 1970 1980 1990 2000 2010 3 Data source: Bloomberg, L.P., Robert Shiller. Data through August 2017. The data depicts the 5-year rolling correlation between the yield of the 10-year Treasury and the value of the S&P 500 Index. Past performance is no guarantee of future results. Different indices and economic periods will produce different results. It is not possible to invest directly in an index.

We think this is important, since periods of low and upward moving rates may be a good backdrop for equities. Exhibit 4 divides the average historical monthly S&P 500 Index performance based on the 10-year Treasury yield during times of rising and falling rates. Not surprisingly, equities fared poorly when yields were high and moving higher, but performed well when yields were decreasing from elevated levels. Interestingly, stock prices also tended to rise significantly when yields were low and starting to move higher. Exhibit 4: Low and Rising Yields Have Represented a Sweet Spot for Equities Monthly S&P 500 Index Returns During Different Yield Environments 10-Year Treasury Yield Range S&P 500 Index Returns During Months of Rising Yields Falling Yields 1-2% 1.8% 0.6% 2-3% 1.6% 1.3% 3-4% 1.1% -0.5% 4-5% 0.8% 0.4% 5-6% 1.0% -0.2% 6-7% -0.2% 1.6% >7% -0.8% 2.3% Data source: Bank of America Merrill Lynch, 1953 through July 2017. Past performance is no guarantee of future results. The returns reflect the average monthly returns of the S&P 500 Index when yields either rose or fell, given where the yield on the 10-year Treasury was. Different indices and economic periods will produce different results. It is not possible to invest directly in an index. The 10-year Treasury yield is still quite low by historic standards at around 2.3%, so we don t believe rising rates and yields are likely to act as a drag on stock prices any time soon. INVESTMENT SELECTIVITY: WHICH AREAS OF THE MARKET MIGHT BENEFIT? We don t believe equities as a whole are likely to suffer during the current period of rising rates, but different areas of the market will likely perform better than others. The closing section of this paper offers our individual views and investment themes. Consider sector performance, for example. In periods of rising rates, equity valuations tend not to expand, so earnings growth becomes the main driver of equity returns. Not surprisingly, sectors that tend to exhibit better growth prospects, such as financials or technology, have generally outperformed during periods of rising rates. Conversely, areas that are incomedriven and act as bond proxies, such as utilities and telecommunications services, tended to underperform, as shown in Exhibit 5. Interestingly, equity markets appear to be more affected than usual by changes in bond yields today than they have in the past. Exhibit 5 shows a higher correlation between equity market sectors and changes in the 10-year Treasury yield over the last five years than over the last 20 Exhibit 5: Sectors Matter. And More Than They Have in the Past Correlations Between U.S. 10-year Treasury and U.S. Equity Sectors 0.8 0.6 0.4 0.2 0.0-0.2-0.4-0.6-0.8 Financials Energy Industrials Materials Cons Disc S&P 500 Info Tech Health Care Telecom Svcs Cons Staples Real Estate Utilities Since 2012 Since 1989 4 Data source: Bloomberg, L.P., as of August 2017. Past performance is no guarantee of future results. Sector performance based on the S&P 500 Index.

Exhibit 6: Dividend Growth Can Help When Interest Rates Rise 140 125 110 Dividend Growers Payers with No Change in Dividends Non-Dividend Payers Dividend Cutters 95 80 0 3 6 9 12 15 18 21 24 27 30 33 36 Data source: Ned Davis Research. Past performance is no guarantee of future results. Data shown is based on the average 36-month performance after all rate hikes since 1972 that occurred on the following dates: 1/15/73, 8/31/80, 4/9/84, 9/4/87, 2/4/94, 3/25/97, 6/30/99 and 6/30/04. Each stock s dividend policy is determined on a rolling 12-month basis. For example, a stock is classified as dividend-paying if it paid a cash dividend at any time during the previous 12 months. Dividend growers and initiators include stocks that raised their existing dividend or initiated a new dividend during the preceding 12 months. The performance shown is for illustrative purposes only and does not depict or predict the future performance of any Nuveen strategy. Different indices and economic periods will produce different results. It is not possible to invest directly in an index. years in both a positive and negative direction. This is likely because Fed policy has heavily influenced economic growth in the post-crisis environment, and changes in bond yields at such low levels may have had an outsized influence on global financial markets in general. In any case, we expect these correlations to remain high for the time being. In addition to sector differentials, we believe focusing on dividends and particularly on dividend growth is a notable consideration. Dividend growth can be an important element of investment performance in any environment, but especially so when rates and yields are rising. Exhibit 6 illustrates how different types of stocks performed in the months following Fed interest rate increases. Companies that grew their dividends tended to outperform those that did not change dividend policies, did not pay dividends or cut dividends. Exhibit 7 considers dividend growth from a different perspective. Dividend growers have also performed well from a risk/return perspective when Treasury yields moved higher. And, as we indicated earlier, Treasury yields probably affect stock performance more than changes in the fed funds rate. During months when the 10-year Treasury yield increased, companies that demonstrated higher levels of dividend growth produced better returns per unit of risk (measured by standard deviation) than those that merely had high levels of absolute dividend yield. Exhibit 7: Dividend Growers Showed Solid Risk/Return Performance Return vs. Standard Deviation When the 10-Year Treasury Yield Advanced 5 Average Monthly Return 1.4% 1.2% 1.0% 0.8% High Dividend Growers 15.0% 15.2% 15.4% 15.6% 15.8% 16.0% 16.2% 16.4% Risk (Standard Deviation) High Dividend Yielders Data source: Morningstar Direct and Ned Davis Research, 1/1/92-6/30/17. Data reflects the average monthly return and standard deviation of two segments of the S&P 500 Index during months when the yield on the 10-year Treasury rose during this time period. Past performance is no guarantee of future results. High dividend growers include those companies that comprise the top 20% of dividend growth in the S&P 500 Index. High dividend yielders include those companies that comprise the top 20% of dividend yield in the S&P 500 Index. Different indices and economic periods will produce different results. It is not possible to invest in an index.

NEXT STEPS: The Benefits of Selectivity and Active Management When interest rates and yields rise, equity investing may grow more complicated. But we believe opportunities still exist. Rising rates do not necessarily lead to market pullbacks, and even when they do, those pullbacks are likely to be temporary. Additionally, we believe changes in the interest rate and yield environment have affected intra-market moves across sectors and across differing dividend yields. We expect this trend to continue. In particular, we believe some areas of the market are more likely than others to outperform, meaning selectivity and active management within equities could grow in importance. Below, we highlight some of our individual views and thoughts about how we are approaching equity markets: BOB DOLL, CFA SENIOR PORTFOLIO MANAGER, CHIEF EQUITY STRATEGIST, NUVEEN ASSET MANAGEMENT Changes in the interest rate and yield environment can be an important factor driving equity returns and these changes make some factors more or less important when looking for attractively valued companies with improving fundamentals. In general, we have been focusing more on cyclical sectors and value areas of the market as interest rates have moved unevenly higher since the middle of last year. These parts of the market tend to perform better when economic growth improves and when interest rates rise. We found that these areas tended to outperform when rates moved higher (such as toward the end of 2016) but did less well when rates stopped rising or fell (such as during periodic flights to quality). From a sector perspective, we re seeing some solid opportunities in financials, focusing on large global banks that may benefit from a rising rates environment. At the same time, we have a mostly unfavorable view toward utilities, which tend to act more like bonds. 6

SAIRA MALIK, CFA HEAD OF GLOBAL EQUITY PORTFOLIO MANAGEMENT, TIAA INVESTMENTS In our view, the current interest rate environment is good for equity markets. Yields are rising, but they remain close to historically low levels. And we think low-but-rising yields favor stocks. In our opinion, 10-year Treasury yield would need to rise to 4% or 5% before it would act as a drag on stock prices. At that point, equity market multiples may begin to contract. Within this context, we view some areas of the market as better positioned than others. To start, we suggest avoiding capital-intensive industries such as industrials. These areas of the market are likely to experience higher borrowing costs as rates rise and could be at a disadvantage. In contrast, we would focus on areas where a preponderance of companies have strong balance sheets, such as the technology sector. We also see opportunities from a capitalization perspective. Small cap stocks have lagged large cap stocks notably this year. We think that trend should reverse as rates rise. Higher interest rates in the U.S. may also cause the dollar to increase, which should offer a relative advantage to small caps over large-cap companies. JIM BOOTHE, CFA CHIEF INVESTMENT OFFICER, PORTFOLIO MANAGER, SANTA BARBARA ASSET MANAGEMENT Many investors pay attention to dividend yield, but we think it is critically important to focus not on absolute yield, but on dividend growth. This is especially true in times of rising interest rates. Many companies that offer impressive dividend levels may actually underperform when interest rates rise. Income-oriented segments of the market tend to act like bonds and may not be a good option when yields are moving higher. In contrast, dividend growers tend to be financially stable and well managed. As such, they tend to have strong balance sheets, which can help limit the effect of higher funding costs often associated with rising interest rates. Regarding specific areas of the market we find attractive in the current environment, we would point to the materials and energy sectors as offering good value. Additionally, we see select opportunities in the real estate sector and favor the media and advertising segments of the consumer sectors. We are more cautious about technology, as we believe much of that sector s strong performance has come from large, non-dividend paying companies. 7

For more information, please consult with your financial advisor and visit nuveen.com. DEFINITIONS S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. Standard Deviation is a measure of the degree to which an investment s actual returns varied from its average return over a certain period. The smaller the variation, the lower the standard deviation will be. The standard deviation is a common measure of volatility and risk. Correlation is a statistical measure of how two variables move in relation to each other. Perfect positive correlation (a correlation co-efficient of +1) implies that as one factor moves the other factor will move in lockstep, in the same direction. Alternatively, perfect negative correlation (a correlation co-efficient of 1) means that variables will move by an equal amount in the opposite direction. 8 RISKS AND OTHER IMPORTANT CONSIDERATIONS This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor s objectives and circumstances and in consultation with his or her advisors. This information represents the opinions of Nuveen Asset Management, TIAA Investments and Santa Barbara Asset Management and is not intended to be a forecast of future events and this is no guarantee of any future result. Information was obtained from third-party sources, which we believe to be reliable but are not guaranteed as to their accuracy or completeness. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Past performance is no guarantee of future results. CFA and Chartered Financial Analyst are registered trademarks owned by CFA Institute. Nuveen, LLC, formerly known as TIAA Global Asset Management, delivers the expertise of TIAA Investments and its independent investment affiliates. Santa Barbara Asset Management, LLC and Nuveen Asset Management, LLC are registered investment advisers and affiliates of Nuveen, LLC. Nuveen 730 Third Avenue New York, NY 10017 212.490.9000 nuveen.com GPE-EQPRR-1017P 279027-INV-AN-10/18