Long-term thinking about short-term interest rates
As we head into the fall, consensus in the investment community is that the Federal Reserve is still on track to approve an increase in short-term interest rates this year, although opinion is divided on whether the timing will be this month or December. Current market developments, including recent global stock market gyrations, China's devaluation of the yuan and persistent concerns about the stability of the eurozone, seem to suggest that December is the more likely scenario.
Regardless of timing, the markets have been fixated for some time now on the potential impact of this move, which would represent the first Fed rate increase since December 2008. I'd like to suggest that, for investors and their advisors, a major concern now is not short-term rates, but rather short-term thinking.
Specifically, we must resist the urge to make knee-jerk investment decisions based on the Fed's next move – especially with regard to investments in enhanced yield assets. In an environment of near-zero rates, many investors sought to bolster portfolio yields through assets such as high-dividend stocks, convertible bonds and real estate investment trusts. Now there are concerns that, as interest rates move up, the prices of such higher-yielding assets will head in the opposite direction.
Higher rates will have an impact on enhanced yield vehicles.
It's true that valuations of high dividend-paying investments have declined sharply this year, as the prospect of a rate increase has become more tangible. The iShares Select Dividend ETF (ticker: DVY), reached a high for the year in late January and has plunged by more than 7 percent since then. The Utilities Select SPDR ETF (XLU), which trades in the opposite direction of rates, is down by more than 11 percent from its high point in January. If the Federal Open Market Committee does raise rates in the next few months, we can expect further declines in the prices of enhanced-yield assets.
Certainly, investors are prudent to ask what to do with their enhanced-yield exposures in a rising rate environment. However, I always counsel clients to keep their eyes firmly fixed on long-term investment goals, and this time is no exception. To focus only on the immediate impact of the expected rate hike gives a distorted picture and can lead to ill-considered investment decisions.
Look at the longer-term economic picture.
The right question to ask is: What kind of economic environment do we expect over the intermediate term – in the next two to three years? It seems most probable that we will see an environment of modest but steady growth in the U.S. and other developed markets as investors are finding the U.S. and its more established counterparts to be the safest bets in an increasingly volatile global market. Most recently, we've seen strong data on U.S. consumer confidence and business investment.
At the same time, a pullback in China's economic growth could have continued repercussions around the world, especially in emerging markets. In such an environment, interest rate increases are likely to be gradual and well-moderated, with the Fed poised to put the brakes on increases if economic growth flattens out or turns negative.
Under this scenario, enhanced-yield assets should still play an important role over the intermediate term. Investors would be well advised to resist the urge to dump such assets in response to the initial rate hike, as yields on high-dividend stocks, REITs, master limited partnerships and other similar assets are likely to remain attractive relative to high-quality fixed income issues. In addition, given that the risk of economic instability is still greater outside the U.S. than within, a continued allocation to U.S.-based assets – including those with enhanced yields – seems advisable.
The latest signs of volatility in the world stock markets just serve to underscore the importance of avoiding short-term thinking. After U.S. and global equities fell sharply in late August, investors were naturally tempted to shift to more conservative asset allocations, but the almost immediate rebound in the stock market rewarded those who patiently chose to ride out the volatility.
When determining the allocation to enhanced yield assets – as in most aspects of personal investing – it all comes down to this: investors and their advisors need to create a road map for wealth preservation and financial security based on their long-term goals – and stay on the road no matter what its short-term twists and turns.
Copyright 2015 U.S. News & World Report
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