The Federal Reserve's plan to curtail its massive asset purchase program has triggered heightened market volatility. Higher long-term interest rates, and the prospect of further rate rises down the road, have resulted in ongoing outflows from bonds. Some investors have shifted their assets toward cash alternatives, accepting near-zero yields in exchange for perceived safety. While stocks have been on an upward trajectory since the recession, uncertainty over whether the economy can sustain the equity bull market has kept many investors from participating in the ascent.
The outlook for the economy and interest rates has significant implications not just for fixed income, but for other assets within the highly interwoven global economy. Even though the Fed is likely to keep short-term rates low for some time, investors may want to reevaluate their asset allocation and investment strategies, and how they can position themselves to meet their goals for income, growth and capital preservation in a normalized rate environment.
U.S. Economy: Transitioning to Somewhat Faster Growth
It's important to remember that the Fed's intent to gradually withdraw its extraordinary monetary stimulus is being driven by something fundamentally positive: A U.S. economy that appears to be gaining strength. We believe the U.S. may be near an inflection point toward a somewhat faster growth rate as the fiscal drags that weighed on the recovery have waned. We expect the pace of U.S. expansion to accelerate to about 3% for the next three years beginning in 2014 — above the 2% trend that marked the past four years.
This does not mean that the Fed is likely to raise short-term interest rates any time soon. While the labor market has shown improvement, unemployment is still above the 6.5% rate that the Fed views as a threshold for ending accommodative policy. Further, inflation appears to be a distant threat, with the Consumer Price Index (CPI) running comfortably below the 2.5% pace that can cause the Fed to become restrictive. As outlined in Exhibit 1, short-term rates have been anchored well below core inflation for some time.
Exhibit 1 // Short-term Rates Anchored Well below Core Inflation
Effective Fed Funds Rate Less Core CPI
As of 9/30/13. Sources: Federal Reserve, U.S. Department of Labor and FactSet
We do not believe that the U.S. economy is very inflation prone, since there is an excess supply of labor and foreign competition remains intense. Disinflationary forces, such as a recently strengthening U.S. dollar and flat to declining commodity prices, have also been at work. As a result, we expect the Fed to keep short-term rates anchored near zero until mid-2015, at which time we expect a gradual rise of about 50 basis points per year. Also, as evidenced by recent yield curve steepening, the severe mispricing in intermediateand long-term yields has been corrected. We believe investors may want to prepare for a normalized cyclical pattern in which short-term interest rates gradually drift higher and the yield curve flattens.
Implications for Fixed Income
An Active Approach Can Identify Opportunities
Investors no doubt have felt the pain of normalizing rates, with performance challenges across most fixed income sectors. In this environment, it makes sense for investors to re-examine their fixed income holdings. Yet it remains important for most investors to keep a strategic allocation to bonds — one that is diversified across sectors and managed for interest rate risk.
For active bond managers, the shifting economic landscape will not only produce new risks but new opportunities as well. In fact, the transition to normalized rates will likely produce dislocations which experienced managers can capitalize on. For example, several years ago, California municipal debt experienced pricing pressure as a result of state budget woes. Savvy investment managers were able to identify undervalued securities that have since performed well.
A stronger economy should also have longer-term benefits for fixed income. Default rates are likely to fall and higher interest rates will allow for reinvestment at higher yields. This can ultimately benefit portfolio returns. In this environment, an active manager can strive to enhance total return potential through strategic use of duration, coupon and maturity management.
Planning for Yield Curve Shifts
Although the yield curve is currently steepening, eventually it will flatten as the Fed begins to raise interest rates. While it remains steep, it may be beneficial for investors to overweight short- to intermediate-maturity bonds. To mitigate interest rate risk, we believe it is better to allow a fixed income portfolio to drift toward a shorter duration (through the maturation of holdings) than to aggressively tilt it toward shorter-term securities. This may also help avoid an unnecessary sacrifice in income over coming quarters while short-term interest rates are expected to remain low.
We caution investors against an over-allocation to short-term securities given the likelihood that the yield curve will flatten as the Fed eventually raises rates. As outlined in Exhibit 2, two-year Treasury yields rose the most during the past three tightening cycles. The chart measures the increase from the onset of tightening to the point that the Fed Funds rate reached its peak.
Exhibit 2 // Shorter-term Treasuries Have Risen the Most in Past Fed Tightening Cycles
Diversification through Core and Satellite Strategies
At BNY Mellon Wealth Management, we believe in a diversified fixed income approach that combines core fixed income holdings with more targeted satellite strategies. Core strategies typically include U.S. dollar-denominated, investment grade municipal, corporate and government securities. Satellite strategies include high yield, emerging markets debt, undervalued municipal securities and higheryielding corporate bonds. The additional yield on many satellite strategies can complement a core allocation by increasing portfolio income and helping to cushion the negative impact of rising rates. In addition, more flexible satellite strategies such as floating rate loans are less vulnerable to interest rate risk since their coupon payments are generally adjusted with changes in rates.
Implications for Equities
Stronger Growth and Low Inflation Support U.S. Stocks
Higher interest rates can be a headwind for equities. However, not all interest rate increases are the same. The reason rates rise is key to gauging their potential impact on stocks. If an increase is due to non-inflationary economic growth, which typically supports earnings growth, stocks may perform well. In fact, as outlined in Exhibit 3, history shows that periods with muted inflation in the 1-3% range have coincided with above-average P/E multiples.
Another important factor to consider is how P/E multiples perform in a low but rising rate environment. Historically, P/E multiples have expanded when the real yield on the 10-year Treasury has risen from low levels. It is only after the real yield hits 4% that P/E multiples begin to feel the pain and start contracting.
Exhibit 3 // Moderate Inflation Supportive of Equity Valuations
Average S&P 500 P/E by CPI Y/Y Tranche (1950 — Current)
S&P 500 P/E based on trailing four-quarter earnings. Source: StrategasRP
Further, low short-term rates may provide a near-term tailwind for equities, as companies benefit from stronger economic growth without a higher cost of debt. Even as short-term rates eventually climb, higher borrowing costs may represent just a muted threat, given that companies on average have far lower debt loads, with significantly higher cash on their balance sheets.
Since subdued inflationary growth typically occurs early in a tightening cycle, early-cycle rate hikes have often coincided with equity gains. As seen in Exhibit 4, the S&P 500 Index experienced a short-term pullback following the last four Fed Funds rate hikes before rebounding and delivering solid gains over the ensuing year.
Exhibit 4 // Strong Stock Market Returns Have Followed Rate Hikes
Average S&P 500 Returns Following the Last Four Fed Hikes
Based on Fed Funds rate from 1/3/89 to 3/18/13, discount rate prior. Initial hike dates: 9/4/87, 2/4/94, 3/25/97, 6/30/99, 6/30/04. Source: Ned Davis Research
Of course, late-cycle hikes in the Fed Funds rate can pose a threat to equities since they signify a more restrictive Fed. These environments can be associated with excessive inflation and dampened economic growth. That is hardly the expectation at present. Rather, the near-term outlook is for the Fed to move from being aggressively stimulative to stimulative — a modest positioning change. It may be years before the Fed shifts to restrictive monetary policy, most likely at some point in 2017 but possibly not until 2018.
Given the backdrop of strong corporate balance sheets, low but normalizing interest rates and muted inflation, we believe equities should outperform fixed income. On a sector basis, a steepening yield curve should continue to benefit financials, which stand to profit on the spread between the short-term rates at which they borrow and the long-term rates at which they lend. As a healthier economy alleviates the Fed's need to inject stimulus, we would expect an improvement in the pace of earnings growth. We also would expect that cyclical sectors such as consumer discretionary, industrials and technology stocks would outperform defensive sectors.
Implications for Alternatives
Strategic Role in Any Environment
Alternative investments on their own certainly can entail significant risk, but as part of a diversified portfolio they can help investors achieve their objectives of growth, income and capital preservation. Alternatives have a low correlation to traditional assets such as stocks or bonds, and can therefore lower risk within a portfolio. Yet many investors have little to no exposure to alternatives. In most cases, these investments have a strategic role in a portfolio.
In the current interest rate environment, we think investors may benefit from alternative strategies that offer income replacement advantages and returns that are less sensitive to rising rates. Investors can also benefit from strategies that have potential for excess returns as a result of the strengthening global economy. It's important to note, however, that these investments are often complex, with varying liquidity profiles. As always, investors should have a thorough understanding of investment objectives and inherent risks before investing.
Compelling Choices among Liquid Alternatives
While equities have delivered strong returns in the current bull market, investors no doubt will recall their lackluster performance during the 10 years between 2002 and 2012. The so-called "lost decade" for equities was caused in part by two significant bear markets beginning in 2002 and 2008. Now, with the Fed's intention to end its quantitative easing program, the bond market has begun to feel the pain. Investors in these market environments can employ alternative strategies that can provide returns that are uncorrelated to equity and bond markets.
For example, long/short equity strategies can provide downside protection in periods of market swings while capturing a portion of the upside potential. They may also provide a cushion for investors if a shifting from easy to restrictive monetary policy triggers additional volatility.
In cases where both stocks and bonds turn negative, absolute return strategies may help by seeking to deliver returns in excess of cash in all market environments. In addition, these strategies can provide a return stream that is less correlated to fixed income investments amid rising rates.
Perhaps one of the greatest benefits of an alternatives strategy is its ability to be untethered to traditional market returns. Managed futures strategies, for example, offer the potential to capitalize on any trend, such as rising rates or inflationary pressures. It is up to the manager's investment acumen to identify a specific global trend that may be favorable. In particular, such strategies may offer attractive return potential later in a rising rate cycle when inflationary concerns increase and commodities stand to benefit.
Real estate investment trusts (REITs) are another type of alternative investment that offers appeal for investors who are searching for income. The low rate environment should support the earnings potential of these investments over the near term, even as they may benefit from higher valuations as the economy expands.
For certain qualified investors, private equity is a less liquid alternative investment that can also benefit from a stronger economy. While low interest rates have helped privately-held firms by way of lower borrowing costs, a rising rate environment is not necessarily bad for the private equity funds that buy a stake in them. As rates rise, deal prices can go down, creating favorable purchasing terms for private equity funds — particularly younger funds with cash to deploy. A stronger economy also supports the growth prospects of private companies, increasing their potential to reach a desired exit point.
Markets are transitioning to a less stimulative Federal Reserve, which ultimately may result in a dramatic shift in the fixed income landscape. Along with it will come new opportunities — and risks — across asset classes. Investors will need to consider the potential impact of this transition not just on fixed income holdings, but on equities and alternative investments. Now is the time to prepare for this shifting market environment.
Re-adjusting an investment portfolio for normalized interest rates will require serious examination and a holistic approach that encompasses a wider range of investment strategies across asset classes. Investors may need to make important modifications to ensure their portfolios are positioned to manage interest rate risk and capitalize on potential opportunities that will arise from shifts in the economy and markets. By making proactive adjustments to investment thinking and strategies, investors will have a higher likelihood for investment success in achieving their goals of growth, income and capital appreciation.
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