In the first stage, tapering should have an adverse effect on interest-rate-sensitive sectors of the market (Treasurys, high-quality corporate bonds, etc.), inflation hedgers (TIPS, commodities) and liquidity dependent sectors such as high-yield and emerging markets.
This is also the stage that will be potentially most volatile, involving wide-ranging disagreements about the timing and scope of policy changes. Just look at market losses that occurred last May and June when virtually all sectors got hurt.
In the second stage, investors should be able to take their cues from previous traditional midcycle periods of adjustment.
Those periods have typically favored growth-oriented sectors and investments that benefit from inflation rates that rise from a low base.
Those may include commodities, TIPs and real estate. Interestingly for fixed-income investors, this has traditionally been a time of relatively low volatility in the rates market. Spread sectors such as the lower tranches of the corporate and muni credit markets should provide better performance, especially if they were beat up in the first stage.
The third stage should kick in once the economy threatens to overheat and the market begins to price in an imminent rise in the Fed funds rate.
The futures market is currently indicating that this may occur sometime during the second half of 2015. During this period, investors should go to the traditional "rising rates playbook" accompanied by a flattening of the yield curve. Expect interest-sensitive investments like Treasurys to face head winds, but they may not necessarily deliver negative total returns over any given calendar year.
If that seems surprising, just look at previous periods of tightening.
The worst year for the Barclays Aggregate Bond Index was 1994, when the Index delivered a total return of around negative 1 percent. That was the worst. Even during the hyper-tightening period of the early '80s, the “Agg” stayed above water as then- higher coupons offset price weakness.
We don't expect the next tightening period to be much different.
So what's the lesson? The lesson is, don't allocate now for a tightening cycle that isn't even on the horizon.
As tapering approaches, expect volatility in most areas of the investment markets; stay nimble and seize opportunities that arise.
Then, if the economy maintains its current trajectory, be ready to shift to a more traditional midcycle, fundamentally driven investment profile as the Fed winds down its large-scale asset purchase program.
Sage, an independent investment management firm, serves institutional and private clients with traditional fixed-income asset management and global tactical ETF strategies. Sage began using ETFs in 1998 and today offers a range of tactical all-ETF solutions, including income-focused and target-risk global allocation strategies. Contact Sage at 512-327-3330 or sageadvisory.com.