Questions That Will Move Markets

November 30, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief strategist of Omaha, Nebraska-based CLS Investments.

New Year’s is the time to make predictions. Thanksgiving is the time to ask questions about the coming year. Asking those questions is often more important than coming up with precise answers.

Market participants often take the opposite approach, asking only the questions frequently emphasized in the media. But going beyond what’s right in front of us can lead to more valuable insights. Below are six important questions on my list for the coming year:

1. How fast will the Federal Reserve increase rates, and when will it stop?

Whether the Federal Reserve had raised rates in September, does so in December or waits until January is important, but not as important as the pace of increases and the stopping point. Nearly seven years removed from the market bottom, market participants are conditioned to very low rates. Within the market, there lingers a deep-rooted belief that rates are going back to normal. I don’t think they are.

My expectation is for rates to increase in December and then increase every second or third meeting. That pace would put short-term rates at about 1% by the end of 2016.

The potential opportunity in this timeline is that if participants overreact to an increase followed by strong data, they will push yields higher. If this happens, it may be a great time to buy intermediate and long-term Treasury ETFs, such as the iShares 7-10 Year Treasury Bond (IEF | A-55) and the iShares 20+ Year Treasury Bond (TLT | A-83).

If rates are expected to rise rapidly, we would expect the dollar to increase too. If the U.S. economy stays strong, international hedged equities would be attractively positioned. International stocks could rise from the benefits of improved economic growth, and hedging the currency means any dollar appreciation associated with higher rates won’t harm investors.

2. How will investors react when they find their portfolios are sensitive to changes in interest rates?

As I mentioned above, investors have become conditioned to low rates. While Treasury bonds offer the purest exposure to changes in rates, other asset classes have high sensitivity too. Corporate bonds, especially high-yield bonds, benefit from plentiful liquidity. If rates rise, liquidity drops. That drop in liquidity could make owning corporate bond ETFs, such as the iShares iBoxx $ Investment Grade Corporate Bond (LQD | A-77) and the iShares iBoxx $ High Yield Corporate Bond (HYG | B-68), more volatile.

Convincing retirees to emphasize income-producing securities isn’t difficult, because the rate decline has allowed valuations to rise on other income-producing securities. Will dividend investors continue to purchase suddenly volatile, high-yielding strategies when bonds offer higher rates and less risk?

The potential for investors unloading high-dividend-paying stocks through the Vanguard High Dividend Yield ETF (VYM | A-97), the Schwab US Dividend Equity ETF (SCHD | A-92) and other high-yielding ETFs leaves portfolios more sensitive. For investors seeking low volatility and less interest-rate sensitivity, the PowerShares S&P 500 ex-Rate Sensitive Low Volatility ETF (XRLV | D-70) offers an interesting opportunity.

3. Will the margins of international companies expand toward the level of U.S. stocks?

The U.S. business community has recovered from the financial crisis more quickly than other regions. Margins in the U.S. now outpace developed and emerging international segments. Should international markets achieve improved efficiency, earnings should rise and valuations could too. Even if international markets narrow only 50% of the gap in coming years, I would still expect a sharp rally in broad international markets, such as in the iShares Core MSCI EAFE (IEFA | A-95) and the iShares Core MSCI Emerging Markets (IEMG | A-99).

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