While the Fed was dovish in September, it doesn’t mean it cannot be hawkish by Halloween with a rate hike at the October meeting.”
The Federal Reserve (Fed) has extended its “zero interest rate policy,” keeping rates at historically low levels as it assesses how slowing growth in China and a stronger US dollar may impact inflation and the pace of the US economic recovery.
Despite market volatility and worries over China, recent US economic data is pointing to a sustained recovery.1 Once the Fed is comfortable that core inflation is also moving toward its 2% target, we believe a rate hike is more likely.
Market volatility across asset classes is likely to increase as investors closely scrutinize upcoming economic data releases to determine when a Fed liftoff may occur. To prepare for the rate hike, investors should consider constructing a diversified portfolio that’s positioned to benefit from a continued US economic recovery.
Data points to sustained US economic recovery
The Fed has said it will be data dependent in deciding when to end its near-zero interest rate policy, and a number of Federal Reserve officials have indicated the economy is strong enough to handle a quarter-point rate increase.2
In the US, household formation, labor growth and consumer sentiment have all trended higher.3 While China’s growth may slow, there has never been a global recession without a US recession, and US recessions have not historically occurred when the labor market is improving and consumers are buying homes.
When the Fed does begin raising rates, its path toward “normalization” should be slow and gradual. The US economy has never been in a zero-rate environment for this long, nor has it relied so heavily on quantitative easing. Once rates are raised, we believe the Fed is not likely to follow a traditional path of increasing rates a quarter-point at each meeting. Instead, it may carefully evaluate future increases against new economic data that points to labor market improvements and rising inflation.
The market consensus is that by the end of this year there will be a 50 basis point increase in the benchmark federal funds rate.4 While the Fed was dovish in September, it doesn’t mean it cannot be hawkish by Halloween with a rate hike at the October meeting.
Considering asset allocation explains approximately 90% of the variation of all returns, the Fed’s delay affords investors the additional opportunity to reexamine and reallocate their portfolios─from bonds to stocks to commodities─ahead of this consensus-viewed tightening cycle.5
Look Beyond the Barclays Agg for Bonds
Rather than relying on a broad fixed income benchmark like the Barclays U.S. Aggregate Bond Index, which has a relatively low yield per unit of duration risk, and represents a narrow slice of the overall bond market, integrating certain fixed income sectors may help diversify a portfolio’s interest rate risk profile without sacrificing yield. Here are three to consider:
1. Short-term investment-grade floating-rate notes with coupons that float with short-term interest rates, such as LIBOR
2. Senior secured loans that feature a low duration profile and floating coupons
3. Higher-yielding debt such as short duration high yield corporate bonds that offer attractive yields per unit of duration
Sectors and Industries for rising interest rates
Reexamining asset allocation for a potential rising rate period should extend beyond fixed income. Investors may also wish to consider tilting core US equity exposures to sectors and industries that benefit from operations positioned to profit from higher rates and improving economic growth. Consumer Discretionary and Financials are two interest-sensitive and cyclical sectors that we feel may benefit most in a potential rising rate period.
Among industries, investors may consider:
Homebuilders: The US labor market continues to strengthen as the unemployment rate recently dropped to 5.1%,6 led by the consistent improvement in full-time employment.7 The strong employment backdrop has buoyed homebuilder sentiment,8 housing demand9 and household spending.10 Incorporating discretionary housing industries, such as home improvement and furnishing retail, and expanding beyond concentrated positions in new home construction firms is the preferred approach to capturing the full effects of this bourgeoning housing market.
Regional Banks: Rising rates should lead to improved profitability as banks’ net interest margin on loans improve. The financial sector and related sub-industries, banks and regional banks, display the strongest positive relationship to rising interest rates with regional banks exuding the highest of any sector or industry.11 As economic conditions have improved, we’ve already seen an uptick in consumer12 and small business lending.13 Banks are more willing to lend amid improved economic conditions, which should drive profitability. Importantly, given that regional banks tend to be closely connected to consumers, we feel they should stand to benefit the most.
The takeaway for investors
While volatility could remain elevated until there is more clarity on rates, it’s important to remember that investors have successfully weathered rising rate environments in the past by keeping an eye on asset class allocation and regularly rebalancing portfolios.
For more guidance on positioning portfolios for a rising rate climate, Investment Professionals can access the following tools:
The Untold Story of Rising Rates Flipbook: This slideshow captures 20 years of interest rate effects on asset class performance.
Portfolio Solutions for a Rising Rate Environment: Use this 1-page quick reference guide to find out which SPDR® ETFs may help mitigate the impact of a rising rate environment.
1Federal Open Market Committee (FOMC) Meeting Minutes, as of 7/2015
2Federal Open Market Committee (FOMC) Meeting Minutes, as of 7/2015
3Federal Open Market Committee (FOMC) Meeting Minutes, as of 7/2015
4Bloomberg, as of 9/10/2015
5Determinants of Portfolio Performance II: An Update by Gary P. Brinson, Brian D. Singer, and Gilbert K. Beebower 1991 Financial Analyst Journal
6Bloomberg, as of 9/4/2015
7The US has as many full-time workers today as when the recession ended almost eight years ago, Bureau of Labor Statistics, as of 9/4/2015
8The National Association of Home Builders/Wells Fargo builder sentiment gauge rose to 61, the highest since November 2005
9Existing home sales reached the highest level since 2007, Bloomberg, as of 9/15/2015
10Household purchases increased by an annualized 3.1% in the latest revision to Q2 GDP, Bloomberg, as of 8/28/2015
11As shown by beta sensitivity to the US 10 Year Yield over the last 36 months, FactSet, State Street Global Advisors, as of 9/15/2015
12“Here’s the One Trend That Could Drive a Rebound in U.S. Consumer Spending,” Bloomberg, as of 8/4/2015
13“U.S. small-business borrowing surges in June: PayNet,” Reuters, as of 8/5/2015