Barring some material shock to the economy, financial markets and/or geopolitical environment over the next three weeks, the Fed finally appears poised to begin the long-awaited process of policy normalization. Following several quarters of mixed messages and false starts, the FOMC has signaled its intent to raise rates for the first time in nearly a decade at the December policy meeting. While much of the attention thus far has been centered upon the timing of the Fed’s first move, the focus will rightly now shift to the likely pace and scope of rate hikes.
On course to raise rates
It remains our view that while the Fed will indeed move ahead and raise rates in December, the policy approach will be an especially deliberate and methodical one. Fed officials are keenly aware of both the fragile nature of global growth as well as the persistence of deflationary pressures, and will therefore act cautiously and pragmatically. We expect this point to be hammered home in both the post-meeting statement and accompanying press conference. That said, the macro backdrop in the U.S. has improved to the point that a normalization of policy is now appropriate. We therefore look for the Fed to raise rates in 25-basis-point increments at every other FOMC meeting, for cumulative rate hikes of 125 basis points by the end of 2016.
The most important question for investors at this juncture, of course, is whether their own portfolios are appropriately positioned for this shift in monetary policy. There has been concern that as the Fed begins the process of normalization, markets could come under pressure—and that is certainly understandable. After all, the initial stages of prior Fed tightening cycles have typically ushered in periods of increased volatility.
But care must be given not to confuse short-term increases in volatility with material and sustained drawdowns. Keep in mind that risk assets often trade higher in the three-, six- and 12-month periods following initial rate hikes (see Fig. 1). There are, however, episodes when markets did not react very well to the Fed’s initial policy shift (1983 and 1994, for example). But those were typically times when the Fed was forced to raise rates more aggressively in response to an overheating economy and/or rapidly accelerating inflationary pressures—neither of which is the case this time around.
Instead, the Fed is beginning the process of shifting away from the extraordinarily accommodative conditions put in place immediately following the financial crisis by gradually “resetting” rates from 0%. We see this as a validation that both the recovery has progressed and deflationary risks have abated to the point that the Fed can now take the first cautious steps toward policy normalization. In the past, equity markets have registered double-digit returns in the year following an initial rate hike if the process was a gradual one. So if form holds, then risk assets will likely provide positive returns over our tactical investment horizon.
How well are we positioned?
Keep in mind, however, that those returns will hardly be uniform across all risk assets. Performance will still depend to a large degree on which risk assets are held, what the regional exposure looks like and how we elect to position across the different sectors. It’s therefore important to assess how well our own portfolio is positioned for the initial stages of the coming tightening cycle.
So here’s how our portfolios stack up for U.S.-based investors:
• Overall, we elect to retain a pro-risk bias as we enter the initial stages of the Fed’s tightening cycle with overweights to both equity and credit. As we’ve already noted, risk assets tend to fare well following an initial rate hike as long as the move is a validation that deflationary risks have abated and not an admission that inflationary pressures are accelerating.
• Within the equity portion of our portfolios, we continue to overweight both eurozone and Japan. Both are in early stages of recovery, with more attractive valuations, better earnings momentum, weakening currencies and an increasingly accommodative policy backdrop.
• While we have closed our underweight on emerging markets, we remain concerned over the impact of a Fed tightening. We therefore position more defensively and seek to avoid those countries that are more vulnerable to the fallout from a tightening of policy and focus instead upon those less acutely impacted. Our overweights include China and Poland, while we have downgraded Turkey and India.
• Within the U.S. equity portion of our portfolios, we continue to reflect a mostly cyclical bias with a preference for those sectors that possess strong secular growth drivers, are less vulnerable to Fed rate hikes, have solid earnings momentum or represent compellingly attractive valuations. This includes technology, select industrials (transports), and equipment and services within the healthcare and energy sectors.
• We maintain a more cautious stand on those sectors that have benefited disproportionately from lower rates and look vulnerable as we enter a tightening cycle. This includes both utilities and telecoms.
• Small-cap stocks tend to fare better than both mid- and large-cap stocks during the early phase of a tightening cycle. This is partly a reflection of their exposure to the improving domestic growth dynamics that a rate hike confirms, and partly because of their more limited currency exposure to the consequent strengthening of the dollar.
• Last, we opt to retain a modest overweight to investment-grade corporate bonds within our fixed income portfolios. With spreads unlikely to widen materially as business conditions continue to improve, the higher yield premium and lower rate risk exposure suggest that credit will outperform government bonds over the next six months.
The bottom line
Each and every monetary policy tightening cycle is different. So while historical return comparisons may prove helpful in providing some context around Fed policy shifts, we must still consider current conditions when positioning investment portfolios. Some may indicate the need to cool an overheating economy, while others are simply intended to reset policy to more macro-appropriate conditions. It is our view that the current cycle reflects the latter rather than the former, and the pace of policy shifts will be both measured and moderate. We therefore retain our selective pro-risk bias as this cycle begins.