Midyear Outlook--part 3: Portfolio positioning as rates rise
by Aldo Ceccarelli, CFA, Wells Fargo Asset Management
In the third of a three-part series, our capital market strategists discuss portfolio positioning as rates slowly rise.
Anar Hooper: This is our Midyear Outlook 2016, where we're talking about building a cushion against slowly rising interest rates. Welcome; I'm Anar Hooper. Thanks for joining us. Gentlemen, thank you for being here today.
Brian Jacobsen: Thank you.
Jim Kochan: You're welcome.
John Manley: Thank you.
Anar: I'd like to talk about our third and final topic: building a cushion against slowly rising interest rates. Jim, this is your wheelhouse here.
Jim: The Federal Reserve [Fed] is, if anything, more likely to raise the federal funds rate slowly, gradually, cautiously, whatever words you want to use, than they are to lower the federal funds rate, particularly if we're right about growth in the United States.
Anar: Do you think it's happening this year?
Jim: Yes. We have more or less assumed that we'll see two increases in the federal funds rate--maybe one, but certainly one and possibly two--so that by the end of the year, perhaps the federal funds rate is in the neighborhood of 1.0% and a year from now in the neighborhood of 1.5%.
Anar: Sounds like the Fed is being cautious and slow.
Jim: They certainly are.
Anar: Thoughts on, Brian, as to why?
Brian: Well, since basically January, the Fed has said we don't know what the balance of risks is. And I think until they can actually hash that out, you shouldn't anticipate that the Fed is going to be in any hurry to hike. Some members of the Federal Open Market Committee might talk about wanting to hike because they're confident in their view of what's going to happen. But other members, especially Chair Yellen, who is the most important one to listen to, are still trying to figure that out. And I think that she would much rather be very cautious and basically err on the side of not hiking than err on the side of hiking and wishing that she hadn't.
Anar: So, Jim, knowing this, what does this mean for the bond market and Treasuries?
Jim: Well, it's not a favorable outlook for Treasuries because the yields are so low right now. A higher yield in the future implies negative returns from the longer-duration Treasuries. The front end of the Treasury market would be OK--the very shorter end--but I think there are better values elsewhere in the fixed-income market. The theme is building a cushion for rising interest rates--that cushion is interest income.
Anar: So where is that interest income?
Jim: Well, we go back to what we've been discussing all along, primarily in the corporate market, emerging markets overseas, but in the high-yield and investment-grade corporate market, single As and triple Bs offer reasonably good income; high yield offers quite good income in this kind of economic environment.
Anar: Thank you, Jim. John, should we fear the Fed when it comes to equities?
John: Not quite yet--not for a while, I think. One of the reasons I became an equities strategist all those years ago is the stocks can do well when the Fed is raising interest rates provided they're not tightening. I, as an equity strategist, don't really care that much how many times they raise interest rates this year. What I care about is whether the Fed is trying to encourage or discourage economic growth over the next 12 months. If they're trying to encourage it, they'll be pushing money toward the economy, and that flows through the capital markets no matter what the rate structure is to a certain degree. So ask yourself a simple question: Is the Fed going to encourage or discourage economic growth? If it's the former, the equity market should do well.
Anar: Jim?
Jim: Well, the best strategy in my mind, even though market yields may go somewhat higher, is to generate good and compound interest income.
Anar: So, for investors, am I hearing emphasize income, not safety?
Jim: Safety has been the wrong strategy now for seven years. In my view, I think it's the wrong strategy for the next 6 to 12 months as well. Emphasize income.
Anar: Brian, for you, some closing thoughts for investors?
Brian: I think when you're thinking about what the Fed is doing, remember that they don't want to throw the economy into a recession. They are very aware that past recessions haven't died of old age. It's been thrown into a recession because the Fed has tightened too quickly. That's just the history of the cycles in the economy, and the Fed wants to avoid that pretty much at all costs. So being gradual and being very cautious, I think, is beneficial to investors, and it's beneficial to the economy as well.
Anar: Gentlemen that will conclude the Midyear Outlook for 2016. Thank you so much for being here today.
Brian: Thank you.
Jim: You're welcome.
John: Thank you.
Anar: And thank you for joining us. I'm Anar Hooper; take care.
Copyright (c) Wells Fargo Asset Management
