As we head into September and towards the prospect of the first Fed rate rise in nine years, investors are increasingly scrutinising US economic data, and the language of the Fed for when the first rate rise, or lift-off, will occur.
I broadly agree with the market view that December is the more likely month for a hike, but I also believe that we are likely to see some short-term market volatility, irrespective of Fed timing. Investors therefore need to consider how best to position their portfolios over the coming months, as well as focusing on the likely timing of rate rises.
For investors in fixed income assets, the so-called taper tantrum of 2013, when the Fed proposed an end to quantitative easing, can act as a guide to the likely market movements we might see. As might be expected in a tightening environment, traditional fixed income assets such as government bonds performed poorly during the taper tantrum, and it is likely that this underperformance would be repeated, as the yield cushion on government bonds would be reduced by higher interest rates. While we have seen some adjustment in bond prices in recent months, prices may need to fall further before this asset class becomes attractive again.
However, some fixed income assets performed well during the same period. Throughout the taper tantrum, assets such as loans and collateralised loan obligations outperformed other fixed income strategies and posted positive returns.
Going forward, their floating rates should help to counter the risk of any rise in US interest rates and an improvement in economic fundamentals (one condition for rate rises) would also increase the asset class’ attractiveness to investors.
Ultimately, any rise in interest rates will be driven either by the strength of the US and global economy, or the threat of higher inflation. If strength driven, then this will be a good environment for growth assets such as equities and infrastructure, as both do well on the back of a growing economy.
However, it is also important to assess asset class performance by region and sector; utilities, for example, would not shelter an investor from the effects of rate rises, as they often act as ‘bond proxies’.
More broadly, while equities should do well in a rate rising environment, some US equities may be negatively affected by the stronger dollar and a reduction in the value of foreign earnings. In light of this, I am currently most positive on European and Japanese equities, as both the ECB and Bank of Japan continue their quantitative easing programmes and both regions benefit from weak currencies.
One of the most obvious choices for investors looking to hedge against an inflation-induced rise will be inflation-linked bonds. Infrastructure also offers some inflation protection, as well as offering the potential to benefit from an upswing in the economy and could therefore be attractive in either scenario. Given the recent slump in commodity prices, however, an inflation-driven rise in rates seems unlikely and our expectations for stronger inflation have been pushed back for now.