What to expect when the Fed raises rates
Joel Dresang: Steve, the Federal Reserve has been talking for years about raising short-term interest rates. We’re probably getting closer. What should investors expect?
Steve Giles: Well, Joel, I think it’s important for investors to recognize the difference between the Fed raising rates because they’re concerned about inflation versus the Fed raising rates because they’re returning to a more neutral monetary policy.
Now, we know that there isn’t any inflation out there. You look at commodity prices over the last year. Consider that for 2016, Social Security recipients aren’t going to be getting a raise. So with no inflation out there, I think it’s safe to assume that the Fed is not going to be raising rates because of any kind of inflation worries.
Joel: So they’re not being as aggressive, so it’s not anything to worry about.
Steve: Well, I wouldn’t say it’s not anything to worry about. The last time that the Fed raised rates was in June of 2006. We actually haven’t seen a rate change since 2008. Anytime you have a change in Fed policy, we want to call those inflection points, and those inflection points are going to create some market volatility.
Joel: What about bondholders? What should people expect in the bond portion of their portfolios?
Steve: Well, I think it’s important for investors to be properly positioned with respect to their durations. Keep in mind, Joel, anytime you see an increase in rates, what’s going to happen to your bond values is the opposite. They’re going to go down.
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But the sensitivity to your bond values is going to be reflective of your durations. The farther out in duration you go – if you think of your bond durations as a teeter-totter, the farther out you go in raising rates, the more you’re going to see a pullback in the values of your bonds.
We’ve been counseling clients to try to find a more intermediate-term range, somewhere in the three- to four- to five-year range. You’re going to have enough of a coupon, enough of a shock absorber, if you will, to absorb any kind of hit to the NAV (net asset value), being mindful that if you go too short, you’re just not going to have enough of an interest yield to offset any kind of short-term pullback.
Joel: What about the stock portion of people’s portfolios? You already said that there should be more volatility in the market. What about stock prices?
Steve: I think we might see some short-term volatility because we get that change in Fed policy, but stocks for the most part have been expecting this for years. I think stocks for the most part have baked this into the equation.
We also have a lot of market breadth right now. If we were to exclude energy from the equation, we’ve got positive earnings growth across the board. Companies report earnings always year over year. We’re going to get to a point here pretty soon where energy companies – oil and gas companies – are going to be reporting earnings that are reflecting positive growth because the losses we saw with the decline in the price of oil from last year will be more than four quarters behind us.
Joel: And low interest rates tend to support stock prices, and that’s the environment we’re in right now.
Steve: Yes and not just do low interest rates support stock prices, but a low inflationary environment can help support stock prices.
Longer term, Joel, what moves the markets are interest rates and earnings. To the degree that earnings forecasts are coming in the high single digits for next year, we’re looking at earnings forecasts in the 10- to 11 percent range for the year after that.
Coming off of these very, very low lows as far as interest rates are concerned, even when the Fed gets done returning to a more neutral monetary policy, if they have a very measured increase over the next couple of years, prevailing interest rates are still going to be historically very, very low, and that’s a positive environment for stocks longer term.
Joel: So what, if anything, should investors be doing with their portfolios now? Or is it too late, since we’ve had a few years of warning of this anyway?
Steve: Well, I think they need to hone in on the balance in their portfolios. A properly allocated portfolio right now should already have the ideal mix between stocks and bonds.
But if you’re to hone in specifically on just the bond side, focus on your durations. Stay in that short- to intermediate-term range, not too short. You want to make sure you have some yield to offset the hit you’re going to take on NAV. And as far as your bond quality, make sure you stay with investment grade. Don’t chase after the higher-yielding junk bond stuff.
On the stock side, I would focus more on domestic. What we’re seeing right now globally is a little bit more of a slowdown, especially in those emerging market areas that are affected by China’s devaluation of their currency.
As long as an investor has a balanced portfolio, they should hold up just fine, but it’s never too late to revisit those balances.
Money Talk Video by Jason Scuglik and Peter May
(initially posted Nov. 12, 2015)