Investors Weigh Possible Rate Increase

Mike Loewengart, VP of Investment Strategy

E*TRADE Capital Management, LLC

06/01/16

The Facts:

The global financial markets were mixed in May. In the U.S., equity markets remained strong as investors saw signs of a strengthening economy, and decided that the prospect of another Fed rate hike may not be so bad after all. Overseas markets were down due to political turmoil in Latin America, and ever-changing odds on a BREXIT. Oil touched a short-term high, helping investors around the globe feel more secure that prices might be stabilizing.

The Impact:

  • U.S. large and small caps advanced in May.
  • International equity markets fell, with emerging markets dropping almost 4%.
  • Fixed income markets were relatively flat, as high-yield bonds experienced gains.

What It Means for Investors:

After years of low interest rates, the landscape might be finally changing. How can an investor take advantage of a rising interest-rate environment? Read on to learn more.

 

A Closer Look

After a volatile start to the month, domestic stock indexes advanced in May, while overseas markets slumped. Latin American investors were conflicted, reacting favorably to positive movements in oil prices, but negatively to political events in Brazil and Venezuela. U.S. investors saw metrics indicating an economy on strong footing, with surprising strength in the housing market, and embraced the possibility of a Fed rate hike sometime in the next few months.

Fed says rate increase “appropriate”: According to minutes released from the Federal Open Market Committee’s meeting in April, leading market indicators suggest that a rate hike may be “appropriate.” This, according to the Fed, is due to a number of factors, including a strengthening labor market, a halt in the dollar’s appreciation, and rebounding oil prices. A blowout new home sales number in April, and a rise in existing home sales for the second-straight month, lent more credence to the Fed’s plan. 

A recovery in oil prices underway: The broader market’s concerns about oil seemed to have eased in May. Although wildfires in Canada and political unrest in Nigeria were disruptive, they can be viewed as temporary situations whose impact is most likely over. During the last week of the month, the commodity touched $50 per barrel, which was up 89% from the 13-year low that oil hit in February 2016. If oil prices settle in this range, investors may have confidence that the bulk of the energy sector should be able to continue its operations without significant financial disruption.

Major Asset Class Trailing Returns as of 5/31/2016

Domestic Equities

The month of May started with volatility, and not much enthusiasm from investors. However, strong housing numbers by month’s end triggered a late rally, as investors accepted the possibility that a potential rate increase in the near future may be a positive indicator of a solid economy.

The large-cap-oriented S&P 500 Index rose 1.80% in May, and is now up 3.57% for the year. This is in sharp contrast to the steep declines at the beginning of the year, and is the third month in a row where the index finished in positive territory.

U.S. small caps slightly outperformed large caps for the month, with the small-cap-oriented Russell 2000 Index advancing 2.25%, the best performer of all the indexes we track. Year to date, the index boasts a 2.28% gain.

Turning our attention to the sectors that make up the U.S. equities markets (based on the S&P 500 sector indexes), the strongest sectors for the month were information technology, health care, and financials. Although the price of oil touched a short-term high mid-month, energy was the worst-performing sector in May, followed by industrials and materials. Year to date, utilities, telecom, and energy have been the best-performing sectors, while health care, financials, and consumer discretionary have been the weakest.

According to the Russell 3000 Growth and Value indexes, both growth and value stocks were higher in May, although growth outperformed value by close to half a percentage point. For the year, however, value is outpacing growth by almost four percentage points.

International Equities

Overseas markets were down in May, as disconcerting political news created anxiety among investors, and an unstable environment for markets. In Brazil, President Dilma Rouseff was suspended from the presidency pending the results of her impeachment proceedings. In Europe, all of Britain—and the world—is cautiously awaiting the June 23 vote to see if Britain will remain in the European Union.

The MSCI EAFE Index, a widely followed measure of developed market performance, fell 0.91% in May. Thanks to rate cuts by their respective central banks, Canada and Australia were the strongest performers, while Asia was weak. Year to date, developed markets are down 1.10%.

The MSCI Emerging Markets Index finished down 3.53% for the month. Latin America was the worst performer, thanks to the aforementioned problems in Brazil. Coincidentally, though, it rebounded sharply towards the end of the month because of the increase in oil prices. The index remains in positive territory year to date, up 2.32%.

Fixed Income

Fixed income markets showed a slight gain in May. The Barclays U.S. Aggregate Index increased by 0.03% for the month, and is up 3.45% year to date.

In the U.S. Treasury arena, the yield on the benchmark 10-year note ticked up one basis point for the month, to 1.84%, and is now down 43 basis points in 2016. (A basis point is one one-hundredth of a percent.) The yield curve flattened in May, as rates on short-term maturities advanced, and longer-term maturities pulled back.

When it comes to individual sectors, long-term U.S. Treasuries were the best performers, followed by high-yield bonds (also known as junk bonds). TIPS were the weakest. Year to date tells a similar story, with long-term Treasuries continuing to be the best performer, followed by high-yield bonds. The worst performer year to date has been short-term Treasuries.

The Bottom Line

With the potential for a Fed rate increase back in the discussion, investors may be wondering how to position their fixed income portfolios for a rising-rate environment. Of course, there’s no magic bullet. But here are several ways fixed income investors have historically responded to the prospect of rising interest rates:

  • Investigate bonds with shorter maturities. Bonds with longer maturities are most susceptible to price declines in a rising-rate environment, so investors may want to take a look at bonds with shorter maturities.
  • Explore counteracting inflation with TIPS. One of the reasons the Fed may raise rates is because it believes inflation will tick up. In that case, investors may want to consider Treasury Inflation-Protected Securities (TIPS). The interest rate on TIPS remains fixed, but the par value rises with inflation (as measured by the Consumer Price Index). Backed by the federal government, TIPS may be a low-credit-risk way to benefit during a rising-rate environment. Keep in mind, however, that TIPS often have long durations, so rising rates without rising inflation can be a tough environment for them and expose an investor’s portfolio to downside risk.
  • Learn about high-yield corporate bonds as a possible buffer for higher rates. Assuming the economy is on firm footing, investors may consider high-yield bonds. These bonds may fare well in a rising-rate environment because they have higher coupons and shorter durations—which means less sensitivity to higher rates. However, there’s more risk in high-yield corporate bonds due to various factors, including higher default risk and the fact that they are not backed by the U.S. government.

Thank you for reading.

Mike Loewengart

Vice President, Investment Strategy

E*TRADE Capital Management

Mike Loewengart is the Vice President of Investment Strategy for E*TRADE Capital Management, LLC. Prior to joining E*TRADE in 2007, Mike was the Director of Investment Management for a large multinational asset management company, where he oversaw corporate pension plan assets. Mike started his career as a research analyst and an investment manager due diligence analyst for the consulting divisions of several high-profile investment firms. He is a graduate of Middlebury College with a degree in economics.