This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is co-authored by Michael McClary, chief investment officer of Akron, Ohio-based ValMark Advisers, which markets the "TOPS" brand of asset allocation models, and by Robert Leggett, the firm's senior portfolio advisor.
Ignoring interest rates in managing an investment portfolio would be like a pilot ignoring the weather when flying a plane. Interest rate changes, like changes in weather patterns, can have an impact on overall investment results in any given year.
We’re never exactly sure what the weather patterns will be, but we’re undoubtedly entering an environment where storms could develop, and investors should always be prepared for the perfect storm to pop up.
In 2014, several asset classes benefitted from a unique cocktail of economic factors and a largely unexpected decrease in interest rates. However, it’s dangerous to expect recent historical trends in the global markets to simply continue, as what has worked in the past is often unlikely to work in the future.
While duration risk paid off in 2014, it could soon be a zero-sum game for many investors. If interest rates reverse course this year, much of 2014’s gains could mathematically be wiped out. And, as many investors found out in 2014, trying to speculate on short-term interest rate movements can be a widow maker trade.
What all this means is that if interest rates rise in 2015 and beyond, there could be a headwind for 2014’s all-star asset classes.
We believe the three following asset classes should currently be under review for investors who feel that interest rates will rise significantly in the coming year, making sure that their exposure is in line with their objectives. We hope that investors adequately recognize and factor in the effect that potentially rising rates may have on overall results of:
- Longer-term bonds
- Defensive Stocks With Attractive Yield
A Study Of Mean Reversion
Some of the best performing asset classes in 2014 were U.S. REITs, long-term Treasurys and U.S. yield stocks. History suggests repeat performances may be unlikely. Consider the following:
- The SPDR Dow Jones REIT ETF (RWR | A-80), returned 31.8 percent, after falling almost 1 percent in 2013
- The iShares 20+ Year Treasury Bond ETF (TLT | A-85) returned 27.3 percent last year after losing about 13.4 percent in 2013
- The iShares Select Dividend ETF (DVY | A-49) returned 14.9 percent in 2014 after returning 26.8 percent in 2013
Current Interest Rate Landscape In The US
Interest rate risk is one of the most important factors we’re focusing on these days. With interest rates near historic lows, we find ourselves entering yet another year focused on interest-rate risk and the potential impact that rate changes may have on our portfolios.
If recent history is a lesson, we can’t simply rely upon consensus estimates of interest rates. Right before 2014, many economists wrongly predicted that interest rates would stay stable or increase. A perfect example was in December 2013, when 43 of 44 economists interviewed by The Wall Street Journal forecast that interest rates would be higher in 2014. The 44th, for the record, predicted that rates would be flat (according to the Wall Street Journal).
Overall, the economists projected an average increase of 62 basis points in the 10-year U.S. Treasury note in 2014. We know now that almost the exact opposite occurred.
While interest rates remain historically low in the U.S., America remains the best relative value for safe money in terms of attractiveness of yield. In comparison to the 2.115 percent yield on the 10-year US Treasury as of Feb. 18, the 10-year German bund was yielding about 0.35 percent.
In its statement at the end of its January meeting, the Federal Reserve left the door open to raising rates this year. Despite recent decreases in inflation, driven mainly by a significant drop in oil prices, the Fed thinks inflation will rise gradually to 2 percent in the medium term. And, regarding the goal towards its other goal of maximum employment, the Fed expects further labor market improvement.
Some investors question whether the Fed even has any incentive to raise rates, given that inflation numbers are still below long-term targets and employment is still below its mandate. One reason may have to do with the timing of recessions and the position the Fed will be in when the next one inevitably hits.
It has been seven years since our last recession. Since the longest the U.S. has gone between recessions is about 10 years, it’s important to recognize that our next recession may well occur in the next five years.
All else being equal, the Federal Reserve may want the ability to lower rates when the next recession hits. In the current landscape, that could be difficult, as rates are already near zero. Therefore, the current situation puts the Fed on a shot clock.
Hugely increasing the maturity of bond holdings at the onset of 2014 would have been an extremely successful speculation. However, if interest rates would have instead risen in 2014, as most major economists predicted, a bet on long-term bonds would have been disastrous.
I’ll put that into an ETF-specific frame of reference. According to data iShares posts on its website, the current effective duration on TLT is about 17.5 years. Therefore, a 1 percentage point rise in rates in the next 12 months could cause a loss in value of over 15 percent.
We saw a recent illustration of this risk. On Jan. 30, the 10-year U.S. Treasury closed at a yield of 1.64 percent, while TLT closed at a price of $138.28. On Feb. 17, the 10-year U.S. Treasury closed at a yield of 2.14 percent, while TLT closed at $126.26—a drop of 8.7 percent for TLT in a bit more than two weeks.