3 Views On What To Do In Face Of Rising U.S. Rates

The latest jobs report, released Friday, blew estimates out of the water. Coming in at 271,000 new jobs for the month of October—exceeding market consensus by nearly 100,000—the number, which came accompanied by a drop in unemployment rates, bolstered the case for a Fed rate hike in December.

Should investors react in any way by perhaps rethinking long-bond and equity exposure? Here’s what three industry experts had to say:

1) “My 2 cents is to stay patient, positioned and prepared to buy when the data is in your favour”: Steve Blumenthal, chairman & CEO, CMG Capital Management Group, Philadelphia

There was nothing but good news in the numbers. Good news is bad. With the Fed more likely to raise rates next month, the market moved lower, the 10-year Treasury yield shot up to 2.32 percent—it was under 2 percent just a few weeks ago. And the dollar gained against the yen and the euro.

Fed members have been more vocal about a December rate increase. Markets were pricing in a 56 percent chance of a hike at the December meeting with the expected hike taking the Fed target to .375. After Friday’s jobs report, the probability of a hike goes up.

Let’s take a step back and jump out of the noise. Investing is relatively simple when valuations are low; it becomes much riskier when valuations are high. Today stocks are richly priced, and when they’ve been this expensive in the past, the annualized 10-year returns have been low. Period.

Current high valuations (median P/E ratio of 20.2 as of Oct. 31, 2015) are telling us that forward returns will be in the 3-4 percent range before inflation and advisor fees. The Fed’s been driving the QE bus for seven years. That ride appears to be ending. The markets inflated with QE. We can’t expect the same response when the juice is pulled away.

My 2 cents is to stay patient, positioned and prepared to buy when the data is in your favour. Until then, reduce and hedge that equity exposure, tactically trade fixed income and overweight liquid alternatives such as long/short, managed futures, tactical all asset, etc.

2) “[We see] decent gains for stocks, modest losses for government bonds and a somewhat firmer U.S. dollar”: Peter Perkins, Macro Research Board, latest research note published 9 November

The early stages of Fed rate hikes are typically choppy periods as investors struggle to understand the monetary path ahead. That will likely be all the more the case in the current cycle given the extraordinary monetary backdrop and uncertainty among investors about how monetary policy has affected asset prices, as well as the Fed’s muddled policy message recently. Nonetheless, despite prospects for some near-run volatility, Fed rate cycles normally correspond with a positive performance by risk assets and a rising stock/bond (S/B) ratio, and we expect such an outcome ahead.

Looking out to 2016, it will be the combination of growth and monetary policy that determine asset market performance. Moderately better, but still middling economic growth, combined with a slowly rising fed funds rate implies decent gains for stocks, modest losses for government bonds and a somewhat firmer U.S. dollar. Such an outcome also implies significant shifts in performance and positioning within asset classes as investors slowly migrate from a conservative to a modestly more pro-growth posture.

The initial phase of Fed tightening could encompass a compression in the forward P/E ratio. However, this will be offset by rising earnings expectations. That was the profile from the past two Fed rate cycles and a similar outcome looks set to repeat, although P/E ratio compression should be less this time given a more gradual Fed cycle.

The start of a Fed tightening cycle, whether in December (as seems probable) or early next year, will trigger significant shifts in portfolio positioning both across and within asset classes. Investors are currently positioned for the persistence of a low interest rate, slow growth climate and will need to alter allocations markedly as growth momentum improves and the Fed slowly hikes interest rates. We recommend positioning for such an outcome on a 6-12 month horizon.

3) “We would encourage investors to remain appropriately diversified in both their fixed-income and equity positions”: Michael McClary, chief investment officer, ValMark Advisers, Ohio

The global economy has experienced a largely unprecedented level of central bank intervention over the last decade. There’s no question that actions by central banks have had profound impact on economic numbers and investment returns, especially since the financial crisis in 2008.

It’s still uncertain what the long-term effects of this intervention will be. Since equity results have been strong and economies are generally improving—albeit slowly—many would argue that the actions have generally had a positive effect on results in the short term.

Like any cause and effect relationship, there’s typically an initial result, then the longer-term effects follow over a period of years. For example, it’s typically positive to feed a hungry animal in the short term. However, if your assistance stops that animal from learning valuable life skills necessary for independence, the long-term results could be negative.

After several years of actions by the Fed that have propped up the U.S. economy and stock markets, we are now entering that awkward phase of reducing the support. If the support helped, it would be conceivable to believe that results would be somewhat lessened when that support is reduced. A concern plaguing investors is that the addiction to Federal Reserve steroids has been going on for so long that many can’t remember when markets existed without training wheels.

For example, after the latest jobs report, we saw several quick reactions:

1. The 10-year U.S. Treasury Yield jumped from 2.22 to 2.34 percent within two hours.
2. U.S. REITs, represented by ticker symbol SPDR Dow Jones REIT (RWR | A-86), dropped as much as 3.7 percent intraday Friday.
3. U.S. utilities, represented by the iShares U.S. Utilities (IDU | A-92), dropped as much as 4.3 percent intraday Friday [Nov. 6, 2015].

We feel that the textbook direct impact of a 0.25 percent rate rise in December is relatively low. However, we think this is not just a normal 25 bp rise. This increase carries an incredible amount of emotional baggage and uncertainty with it. As such, we would encourage investors to remain appropriately diversified in both their fixed-income and equity positions. This is a difficult time to take a big bet in any direction.

For the remainder of the year, we see interest rates, oil prices and the value of the U.S. dollar being primary drivers of stock and bond year-end prices.

Contact Cinthia Murphy at [email protected].

[Additional reporting by Rachael Revesz]