Fed rate hike: asset allocation

Higher rates aheadThe era of zero rates may be over, but market volatility isn’t done yet, and fund managers have reacted by advising investors to be selective in their asset allocation.

European stocks are predicted to do well, but there are also positive predictions for European high yield bonds.

At the same time, there is a warning about countries and assets with sensitivity to the US dollar. The currency is broadly predicted to increase as the Federal Reserve slowly increases rates.

Asset manager BlackRock says in its reaction to the Federal Reserve’s first rate hike in a decade yesterday, that financial market volatility is likely to remain elevated.

Equities may find it difficult to advance in the face of an appreciating dollar and stagnant corporate earnings, placing greater importance on investment selectivity, the firm says. However, BlackRock also says it prefers stocks over bonds, particularly European and Japanese equities, and market-neutral strategies such as long/short equity and credit.

Nick Gartside and Iain Stealey, fixed income fund managers at JP Morgan Asset Management, say global bond yields will stay lower for longer.

The managers warn the dollar will appreciate because the response of other major central banks, including the European Central Bank and the Bank of Japan, will be to ease monetary policy. That is a headwind for corporate earnings and the US economy, they say.

“The initial market reaction to a higher Fed Funds rate may be increased volatility and potentially higher rates in the near term, but eventually rates will rally as it becomes clear the pace of rate hikes remains slow and the terminal rate remains low.”

The managers are allocating more to bonds with interest-rate sensitivity, which includes the US and Europe, where yields are drifting downwards. It is also true for some of the peripheral European markets, including Italy and Spain.

European high yield continues to look strong, they add, saying: “Whether it is investors seeking yield or just the benefits that accrue to companies from more stimulative policy, the European high-yield market makes a lot of sense.”

Ken Taubes, US chief investment officer of Pioneer Investments, says investor uncertainty may continue as the Fed’s rate decisions are dependent on data – and this is another driver for market volatility.

There is also a divergence in views between the market and the Federal Open Market Committee (FOMC) regarding rate increases – yet another volatility creator. The market continues to price in only two rate increases, compared to the four increases the FOMC has projected.

Wider credit spreads may represent a good opportunity for investors, he says, and the recent sell-off in the high yield and bank loan markets has created select buying opportunities in many sectors.

“We believe bank loans offer particular value as floating rate, senior-secured assets. The bank loan market also has significantly less energy exposure than the high yield market.” Pioneer is cautious on the energy sector.

Taubes expresses caution also on emerging markets. “Higher rates will hurt those countries with significant external US dollar-denominated debt,” he says.

Asia is the least vulnerable emerging market region, with China, India and Philippines showing the most resilience.

David Lloyd, head of institutional public debt portfolio management at M&G Investments, raises a concern about how investors will react to a period of interest rate normalisation.

Low rates will have caused some investors to take extra – and perhaps unfamiliar – risks in pursuit of yield, he says, while other players will have increased their borrowing.

“It will take some time before we will be in a position to assess the effect of higher rates on such decisions,” Lloyd says.

He also says the Fed may need to withdraw liquidity in order to re-enforce the intended monetary policy effects of the rate rise – and again, this will be another source of volatility.

©2015 funds europe