Is a Rate Hike Coming? Consider Shedding Some Duration
I know. I know. Everyone’s tired of even thinking about a possible rate hike when the Fed meets on September 20. We’ve been going down the same road, for so long, that it seems almost inconceivable that Janet Yellen and the Fed will actually increase interest rates. And despite Yellen’s Jackson Hole speech stating that the case for a rate increase has “strengthened” in recent months, she also makes it clear that the decision is still on the table. Clearly the mystery won’t be solved until September 20.
But what if the Fed does raise rates? Are your clients’ fixed income portfolios prepared?
The skepticism surrounding a hike isn’t unfounded. After all, the list of events driving global economic uncertainty is long. Brexit. Terrorist attacks in France. The earthquake in Italy. The China “slowdown”. Plus, the US economy is still growing at a sub-2% annual clip. And yet, despite all these factors, many analysts are saying this may be the time when rates finally get a hike. The market itself is weighing in: the CME Group 30-Day Fed Funds futures are signaling a 79% chance of a 0.25%-0.50% hike at the September meeting. To understand the thinking behind those numbers, let’s take a look at the two main indicators of a hike in interest rates: inflation and GDP.
Inflation on the rise
Here’s the main reason I (and many others) think a rate hike may be in the cards: Inflation is increasing—and increasing more than many people think. Core inflation, which is the consumer price index (or “regular” inflation rate) excluding the food and energy sectors, has been running above the Fed’s target rate of 2% for the past 9 months.
The recent Bloomberg article “Inflation isn’t dead; it just might not be where you think it is” highlights the vast discrepancies between rates of inflation for various goods and services. Many of the basic things we need to live have high inflation rates. In the past 20 years, food is up 64%, medical care 105%, childcare 122%, housing 61%, and college education a whopping 197%. At the same time, many discretionary items have experienced significant deflation. TVs are down 96%, toys 67%, and wireless service 45%. Clearly the current level of inflation is made up of wildly divergent categories of prices, and a change in the mix can quickly drive the overall level of inflation up or down, making defining the “real” inflation challenging indeed.
The second primary metric the Fed looks at when judging whether market conditions warrant Fed interest rate action is “real GDP” (or GDP adjusted for inflation)—a measure that has failed to meet the Fed’s 2% annual target for the past three quarters. However, this target threshold has been met or exceeded in 6 of the last 9 quarters. While some see a recent trend of strengthening, just as many see a long slow decline driven by many of the macroeconomic conditions mentioned above, as well as an aging workforce and other demographic factors.
So have the Fed’s “2 and 2” conditions of core inflation and real GDP growth been met? And if they haven’t been met statistically, are they close enough to warrant an increase later this month? Nobody knows—but whatever the decision, now is a good time to consider the impact a “yes” vote may have on your clients’ portfolios.
Today is one of the “cheapest” times to adjust fixed income portfolios
The longer the duration of a fixed income instrument, the more its price changes in the face of a change in interest rates. This means that positioning your clients’ fixed income portfolios generally means reducing duration. Even if you are not convinced rates are going to rise, now is a good time to consider reducing durations, largely because it’s currently pretty cheap (more about that in a moment). So instead of longer-term maturities—say 7 to 10 years—you may consider moving to a shorter duration of 2 to 3 years. While every strategy is dependent upon the client’s individual situation, generally speaking, shorter is better when rates are rising. Here’s why:
The US Treasury yield curve is currently very flat, meaning that the difference in yield between the various maturities is not that great by historical standards. With that in mind, you can shed some duration in your clients’ portfolios without giving up much yield. For instance, the spread between the 2-year yield and the 10-year yield is currently around 0.80%—0.68% lower than a year ago and significantly less than half of where it was two years ago. (Incidentally, today’s relatively flat yield curve is yet another sign that the fixed income markets are anticipating a Fed rate hike.)
If you’re guilty of tuning out any news of a hike, you’re not alone. “Normalcy bias,” as it applies to interest rates, is a very real effect that influences us to assume that the current low rate environment will persist indefinitely. The Fed’s lack of action has fueled this bias. But as September 20 looms, don’t let complacency take hold. The Federal Reserve Board just may decide September is the perfect time to initiate a rate hike, or even begin a series of hikes.
With all this in mind—inflation on the rise, real GDP growth, flat yield curve—now may be an ideal time to get ahead of the curve and position your clients’ fixed income portfolios for higher rates by shedding some duration.
What's an Investor to Do When History Doesn't Repeat Itself?
We’re in an era of extremes. It seems a day doesn’t go by without the word “historical” popping up in the financial news.
The equities market and consumer debt are at historical highs. Interest rates and high-yield credit spreads are at historical lows. We haven’t seen even a 5% pull-back in the market this year—for the first time since 1995—and the DJIA is exhibiting its narrowest trading range in history. These are indeed historical times. And whether this fact has you filled with extreme optimism or extreme pessimism, you have some important decisions to make going forward.
There are theories about how we landed in this particular era of extremes, and most are rooted in the significant changes that have impacted both how we live and how we invest. At the top of the list are globalization, automation, and the largest aging population in history (yet another “historical” to add to the list). It’s said that the most dangerous words in investing are, “it’s different this time,” yet one has to wonder if, in fact, it really is different this time. Not just because of the historical market highs. After all, there always has been and always will be a new market high waiting around the corner. What’s different today is the sheer number and confluence of these extreme highs and lows—and their duration. It’s a situation no investor has experienced before, which can make these waters feel pretty daunting. History repeats itself, and investment strategies are largely built on that conviction. But what do we do when it doesn’t? When history fails to repeat itself, how can investors plan for tomorrow with confidence that they are positioned to protect their assets and gain a reasonable level of yield?
The first step is to recognize that, at least in many ways, the investment landscape really is different this time around. All you have to do is look at the numbers to be sure of that fact. And the catalysts I mentioned before—globalization, automation, and the aging population—aren’t going anywhere. If anything, the impact of each will only grow as time moves on. What that means is that there’s no way to predict what’s coming next. The only thing we know for certain is that predictability is a thing of the past (if it ever really existed at all). The result: you need to approach your portfolio differently than you ever have before.
Your goal, of course, is to find return given a risk tolerance. Current yield is an important part of total return and getting it is an elusive proposition in today’s market. If, like many people, you’re less than confident that the four major sectors that currently drive the equities market—healthcare, discretionary, tech, and financial—are poised to continue to rise at even close to recent rates, it may be wise to seek out alternatives to help drive yield without adding more risk to the equation.
But if alternatives are the wise path forward, which alternatives are the best options?
Real Estate Investment Trusts (REITs), Business Development Companies (BDCs), and energy stocks, traditionally the favored “non-correlated alternatives,” defied expectations when the stock market crashed in 2008, inconveniently revealing high correlations just as the equities market began its freefall. Anyone who was invested in these alternatives at the time knows all too well the devastating impact “non-correlated investments” can have on a portfolio, especially when they fail to do their job when it matters most.
Luckily, there is one alternative that can be counted on to remain uncorrelated to the traditional financial markets and, ultimately, deliver that precious yield: life insurance-based investments. And because this asset is literally built on one of the irreversible catalysts of change, the aging Baby Boomer population, owning life insurance may in fact be the ideal alternative to help investors generate non-correlated returns, regardless of where the market turns next. Even better, these investments typically deliver those returns with very low volatility.
What makes life insurance different is that, unlike typical alternative vehicles, secondary life insurance returns aren’t based on the economy. Instead, they are inherently non-correlated because returns are based solely on the longevity of the individual insureds.
As much as we would all love for the bull market to continue on its merry way, one thing history does tell us even today is that a bear market will come. It’s only a matter of when. As you strive to hedge your portfolios and prepare for the inevitable, life insurance-based investments are one tool that can help you achieve the three things you need most: diversification, low volatility, and yield.
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