Kevin Mahn, President & Chief Investment Officer, Hennion & Walsh
Investors continue to listen for clues from the Federal Reserve (“Fed”) and are making adjustments to their portfolios to brace themselves for an inevitable environment of rising interest rates. Whether the Fed actually increases rates later this year, in 2014 or by the middle of 2015 is somewhat irrelevant as market perception of interest rates has already changed and affected bond prices and their associated yields. Reductions in the Fed’s monthly bond purchase program (which could start as soon as later this year but is more likely to start early in 2014) will also impact bond prices and yields. As result, we would expect the rotational shift out of fixed income funds and into equity and alternative asset class funds to continue.
We contend that the market volatility that was exhibited throughout the period of the federal government shutdown will likely ratchet-up as the revised deadline for the ultimate decision on raising the debt ceiling approaches early next year. Until that point in time, we do see more upside potential for the equity markets for the balance of the year, with a potential Santa Claus rally to close-out the year, accompanied by less downside pressure on bond prices. The rationale behind our viewpoint on equity and bond markets can be found in the current state of the “Goldilocks” U.S. economy that is not too hot to encourage the Fed to begin their tightening process and not too cold to cause the economy to fall back into a recessionary state where company earnings would suffer. To this end, we also believe that sub-3% GDP growth will continue for the balance of the year and significant improvements in the job market will likely not be seen until 2014.
While we see more upside potential for stock market investors in 2013, we still encourage investors to build and maintain diversified portfolios, incorporating a wide range of different asset classes and sectors where appropriate, given the many political and economic uncertainties in the market as well as the likelihood of future surprises from the Fed. Given the many moving pieces in the global investment puzzle, investors would be wise to re-visit their asset allocation strategies to help ensure that they have the diversification in place to withstand potential periods of heightened volatility as well as the breadth of asset classes and sectors to help deliver risk adjusted growth opportunities. With this in mind, we suggest the following portfolio management ideas for careful and thoughtful consideration remembering that any investment portfolios should be custom tailored to an investor’s specific financial goals, income needs, investment timeframe and tolerance for risk.
- Consider Developed and Emerging Market International Equities for Diversified Growth Portfolios
Despite the headline risks that still exist on the continent of Europe, we believe that selective growth opportunities still exist in Europe, primarily in Northern Europe and other developed and emerging markets (which have lagged developed markets thus far in 2013) outside of the U.S. in general, for investors over the course of the last quarter of the year. Emerging market equities, in particular, appear to us to remain deeply discounted at this stage and worthy of a continued price rebound. With this said, we also see upside potential for U.S. equities where the Small Cap asset is currently outpacing both Mid-Cap and Large Cap asset classes.
- Review Asset Classes that have Historically Benefited from Rising Rate Environments
While we do not believe that the Fed is going to raise interest rates, or dramatically reduce the size of their balance sheet, anytime soon, it is clear that the perception of rising interest rates has changed in the marketplace and thus it is appropriate to consider making adjustments to investment portfolios to brace for the reality that interest rates and/or yields will inevitably be/have been rising. Recognizing that past performance is not a guarantee of future results, according to research report from Capital Innovations entitled, “Most Bonds and Some Stocks Could Suffer from an Increase in Long-Term Rates”, areas such as senior loans/floating rate notes, convertible securities, high yield fixed income and certain sectors of common stocks (such as Materials, Information Technology, Energy, Consumer Discretionary and Industrials) have generally benefitted historically from rising interest rate market environments.
- Continue to Take Advantage of Growing Sectors of Global Real Estate
Despite the recent pullback in real estate due to fears over rising interest rates, we believe that there is a sustained momentum with respect to the housing recovery in the U.S. and overseas. As a result, the Real Estate Investment Trust (REIT) asset class, which is comprised of many different sectors of real estate including, but not limited to commercial and residential real estate, and related international real estate investment strategies, are worthy of consideration. To this end, Oppenheimer Funds suggested in an August presentation entitled, “REITs: More Room to Run?” that since 1973, REITs have averaged seven years of positive returns before turning lower. The current streak of positive REIT performance has lasted four years…and counting.
- Bonds are often Effective for Income and Growth-oriented Portfolios
It has long been our contention that, for income oriented investors, bonds can provide for a dependable and consistent stream of income, and principal protection when held to maturity. Bonds, whether they are Municipal, Government or Corporate bonds, can also provide for compounded growth opportunities when the income received from the bonds is reinvested.
Additionally, for growth-oriented investors, fixed income securities can provide investors with downside protection and diversification within a growth portfolio especially in a highly volatile market where additional, measured, short-term flights to quality are likely.
In our view at Hennion & Walsh, investors should be careful not to miss out on the income and diversification opportunities offered by Bonds by trying to time future, potential changes in interest rates. History has shown us that trying to time the market, or time interest rate increases or decreases, is often an exercise in futility. With this said, it is important to understand that when interest rates do increase, bond prices may fall and yields may rise. However, rising interest rates should not impact the interest that bond holders receive on their bond holdings nor should they change the ability of these investors to receive par value on their bond holdings at maturity. Bond fund investors, on the other hand, may see the interest they receive on their fund holdings change in a rising rate environment and will not receive par value at maturity as there generally is no set maturity on bond funds.
While allocations to Bonds may vary based upon market conditions and investor objectives and risk appetites, Bonds can still find a home in most investment portfolios throughout most market cycles.
Disclosure: Hennion & Walsh Asset Management currently has allocations within its managed money program and Hennion & Walsh currently has allocations within certain SmartTrust® Unit Investment Trusts (UITs) consistent with several of the portfolio management ideas for consideration cited above.