Why a US rate rise is no cause for panic

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Written by: Adam Lewis
01/12/2015
While December is traditionally a time to be panicking about getting everything ready for Christmas, one thing on investor’s minds this year just as much as last minute shopping is the actions that will be taken by the US Federal Reserve.

It is now becoming increasingly likely that the first US interest rate hike will take place this month.

Of course, never take anything for granted as many predicted the first move was going to be made in September only for the Fed to backtrack. However recent positive jobs data and the latest minutes from the central bank’s October meeting, seem to suggest a 0.25 basis points rise is coming this month.

Indeed given how much the idea of the upcoming rate rise has been flouted in the media, Chelsea Financial Service managing director Darius McDermott, says investors will now be more worried about rates not rising in December.

It has nearly been a decade since rates were last raised in the US, with the last hike taking place in June 2006. As in the UK, a wave of cuts took place during the global financial crisis, with the last reduction in December 2008 to the current 0.25% where it has stayed ever since.

So, is there anything UK investors should be doing with their portfolios ahead of the expected rise?

“The first thing to say is don’t panic,” McDermott says. “Raising rates is a sign of strength in the economy and is something the market needs, however we do not expect it to be the start of a rapid move upwards in which rates will end next year near the 1% mark.”

This is because McDermott says while the US economy is solid, it is not “booming”. He notes the recovery has been the worst to follow a recession in history and as such he only anticipates one, or maybe two quarter point rises, more as a statement of intent from the Fed.

In this environment the most obvious asset class to be affected would be bonds. He says longer duration bonds would look less appealing, while shorted dated ones would be less affected.

“If however I am wrong and rates do go up much quicker, you would need to look more closer at your overall bond portfolio, but given the diversification and income benefits bond funds provide, we would certainly not recommend selling out completely.”

He adds: “Most bond funds are 80% hedged to sterling so will be less affected by any currency moves that result from a interest rate hike, so you should not expect capital values to be that adversely affected.”

Ryan Hughes, a fund manager at Apollo Multi Asset Management, has been running a low fixed interest rate exposure in his portfolios for some time and agrees with McDermott that it is the speed of the rate rises investors need to focus on rather than the first symbolic hike.

“Most of the impact of the initial rate rise has been priced in by markets so we are not expecting a big reaction upon the news,” he says. “The market’s attention now is what will follow, and if the speed of hikes are faster than expected it will be very painful for bond markets and that is a risk investors need to be aware of.”

Indeed Hughes notes how volatile UK gilts have been this year. Far from the risk-free asset they are often perceived to be, he says they have seen rises and falls of up to 6% in 2015. He adds that investors need to also be wary of their currency exposure and understand the risks associated with hedged and unhedged investments.

“The currency market is always the fastest to react to any news and while most investors in the UK will be invested in sterling assets, if thy have any US dollar exposure they should make sure it is unhedged,” he says.

What of the equity opportunities that could result from the Fed’s move? BlackRock’s global chief investment strategist Russ Koesterich says adopting a modest tilt towards US large and mid cap stocks is a prudent strategy in a monetary tightening environment.

“At first blush, the seems counterintuitive given expectations for a stronger dollar,” says Koesterich. “Generally, a strong dollar is seen as more of a headwind for large caps, which have a greater exposure to international sales.”

However, he says that this year has demonstrated that this relationship is more “complex”. As such, while a stronger dollar has proved a headwind for large-cap company earnings, he says small caps have actually been underperforming.

“Part of the reason has to do with why the dollar is appreciating: rising real interest rates,” he adds. “US real 10-year rates are up roughly 60 basis points since the end of January, which in turn is having an impact on small cap valuations.”

This, notes Koesterich, is consistent with history and as such he favours a “modest tilt” toward large and mega-cap names “which also have the advantage of cheaper valuations relative to the market”.

Hughes adds he would be concerned about bond proxy equities during a rising rate environment. These are stocks such as Unilever, which are most known for paying out dividends to investors, making susceptible to some of the same risks being faced by the fixed income market.

McDermott adds: “In general I wouldn’t be making any portfolio changes ahead of the rise, unless you think it won’t happen in December. If that was the case you could move some of your portfolio into cash and then buy more equities when things get cheaper.”

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