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.
While equities should do well in a rate rising environment, some US equities may be negatively affected by the stronger dollarHowever, 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.
The implications for the commodity sell-off extend beyond its impact on inflation, with commodity-exporting emerging markets also being impacted. The combination of commodity price falls and a stronger US dollar, partly driven by the prospects of a Fed rate rise, could represent a double blow to local emerging market debt.
This is particularly the case for countries which have failed to pursue a structural reform agenda, such as Brazil. However, as the rate rising cycle matures and the dollar reaches its peak against emerging market currencies, we could see valuations becoming more attractive. Of course, these opportunities need to be considered with a view to fundamentals, which could remain weak.
Any decision to raise rates is likely to further strengthen the US dollar. While it may have reached the limits of its strengthening against emerging markets currencies, we are likely to see a further accentuation of US dollar strength against the euro and Japanese yen.
Divergent monetary policies by central banks support this thesis, for as the Fed looks to tighten, both the ECB and Bank of Japan are set to continue with their QE programmes. This loose policy should contribute to growth in both regions, through the shared tailwinds of weak currencies and low inflation.
Ultimately, I think the best means of mitigating potential volatility generated by a Fed rate rise is to build a diversified multi-asset portfolio. To achieve this, investors should consider the intrinsic properties of each asset class, as well as their regional exposure and correlation to other asset classes over time.
Although volatility is clearly a risk to portfolios, investors should remember its potential to present attractive entry points for different asset classes. Whenever it happens, the Fed’s rate rise may prove to be an opportunity as well as a risk, and an actively managed multi-asset portfolio can take advantage of this from within a low-volatility framework.
Eugene Philalithis is portfolio manager of the Fidelity Multi Asset Income Fund
Key Points
December is the more likely month for a hike in the Fed rate
The taper tantrum of 2013 can act as a guide to the likely market movements investors might experience when rates are first announced
An obvious choice for investors looking to hedge against an inflation-induced rise are inflation linked bonds
