Ask DWM: How Does the Likely Fed Rate Hike Impact Your Asset Allocation and Investments?

janet-yellen

Investors and markets are watching this week’s Fed meeting very carefully. Fed Chairwoman Janet Yellen and Fed officials appear to be moving toward raising short-term interest rates this year. Most expect September will mark the time of the Fed’s first rate increase since 2006. A key challenge for the Fed will be the communication of where future rates are going.

We all remember two years ago when Fed Chairman Ben Bernanke created a “taper tantrum” (and threw all markets in chaos for one month) when he signaled it was thinking about ending the QE program. Chairwoman Yellen wants to avoid that and has recently been emphatic that she expects rate increases to be slow and gradual once they start. In fact, in a March speech in San Francisco, she used the term “gradual” or “gradually” 14 times.

The U.S. economy is making progress, with strong job gains and rising wages. Auto sales are way up and factory machines are humming. Small business and consumer sentiment is up as are retail sales. The Producer Price Index rose slightly higher than expected. This data is likely too strong for investors or the Fed to ignore. So, yes, it looks like a rate hike will likely occur this year.

Of course, none of us can control when the Fed will raise rates, what rates will be longer term and how well the Fed communicates the future. We can, on the other hand, control our asset allocations and our investments. That’s where our focus should be.

Let’s revisit our annual DWM seminar in October 2013 entitled “Rising Interest Rates: Should I Be Concerned?” Here’s a quick summary of the key points that are still valid today.

  • The bond bull market may be over.
  • Bonds still play a vital role within an overall portfolio as do all of the asset classes.
  • Equities typically perform well in rising interest rate environments, with the “sweet spot” being when the 10 Year Treasury Bond rates are between 3% and 4%.
  • Use of multiple asset classes lead to non-correlation effects that ultimately lead to better long-term results.
  • One needs at least 15% in alternatives to make a difference.
  • Stay invested.

So, focusing on asset allocation, you should start by revisiting your risk profile. This includes risk capacity, risk tolerance and risk perception. Your risk profile is unique. You need to look at your long-term financial goals and plan and honestly assess how you are “wired.” It’s not as simple as looking at your age. We work with clients in their 80s who have an aggressive risk profile and clients in their 30s who have a conservative risk profile. Your risk profile will determine your asset allocation and therefore your portfolio mix of equities, fixed income and alternatives. In the long-term, your asset allocation is the primary (90%) determinant of the return of your portfolio.

2013 was a watershed year for fixed income. For three decades, fixed income had always been an asset class with low risk and good returns. The “taper tantrum” signaled the start of the end of the bond bull run making fixed income riskier and reducing the likelihood of 8% annual returns going forward. Given this change in risk/return characteristics within the fixed income area, the same risk tolerances score from prior years may not necessary lead to the same asset allocation mix. Hence, many DWM clients reduced their allocation to fixed income in 2013, some quite significantly.

At the same time, DWM fixed income holdings were re-positioned in an effort to reduce risk and potentially increase returns for an expected rising interest rate environment:

  • Reduced duration (when interest rates rise, bond with the longest maturities suffer the greatest drop in price)
  • Added international developed and emerging exposure
  • Added floating rate exposure with very low duration and ability to perform in rising markets
  • Continued diversification through low cost vehicles
  • Kept credit quality solid

So, with all the uncertainty regarding when, how high, and how often the Fed raises rates and how the markets will react to these changes, we suggest you focus on what you can control. If you haven’t already done so, now is a great time to review your asset allocation and your investment holdings. Our DWM clients know that is one of the highlights of our meetings with them, hopefully quarterly or even more often when appropriate. For others, we’re happy to help provide a second opinion. Just give us a call.