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- There's an area of the stock market that will outperform amid higher interest rates, Charles Schwab said.
- The bank pointed to short-duration stocks, which beat the rest of the market in 2022.
- Their outperformance could continue if interest rates stay high, Charles Schwab said.
Stocks have been throttled by high volatility and rising interest rates over the past year, but there's an area of the market that could outperform as long as rates stay high, Charles Schwab said.
"If central banks merely stop hiking and hold rates steady (or cut marginally) at relatively elevated levels, then short-duration stocks may resume their outperformance," chief global investment strategist Jeff Kleintop said in a note on Monday, referring to companies with immediate potential for cash-flow generation.
While the MSCI World Index plunged 17.8% last year, short-duration stocks saw a 0.4% return. And from August 2020 to the end of 2022, the MSCI World Index saw a 18% return, while high-quality short-duration stocks saw a 55% return over that time period.
That's thanks to rising short-term interest rates, with central bankers hiking rates over 1,700% in the past year to control inflation. The aggressive tightening cycle has weighed heavily on most of the stock market, but it's been positive for short-duration stocks, which have more timely cash flows.
And in March, the only period when short-duration stocks didn't outperform the rest of the market was the 10 days following Silicon Valley Bank's collapse, Kleintop said.
Markets initially raised the odds that the bank's failure would spur the Federal Reserve to cut interest rates later this year. But central bankers have signaled the opposite, with Fed Chair Jerome Powell warning that interest rates would stay elevated through the rest of the year.
Volatility stemming from Silicon Valley Bank has also smoothed over since the initial panic, with troubled banks regaining their footing.
"In the absence of additional financial instability, central banks might not engage in rapid and aggressive rate cuts later this year as inflation remains well above target levels," Kleintop said.
He added that though inflation is on the downtrend, prices could rebound in move in a "wave pattern," which could also keep interest rates high and cause short-duration stocks to outperform the rest of the market.
Markets have also begun to price in higher-for-longer rates, despite earlier expectations of an imminent rate cut. Investors are now expecting just an 11% chance of a 25-basis-point cut in July, down from 38% just a week ago, according to the CME FedWatch tool.