Nervous investors — and their financial advisors — watched closely on Monday for signs of where the markets are headed now that the Federal Reserve has spoken and U.S. government bond yields have headed to their highest levels in almost two years.
On Monday, Treasuries extended their selloff, with the benchmark 10-year note yield reaching as high as 2.667% by midafternoon, and stocks dropped across the board.
Economists, meanwhile, are trying to figure out just where the Fed is headed — for example, Bank of America-Merrill Lynch’s Global Economics Research team said Thursday that it didn’t expect the Fed to begin tapering the pace of its quantitative easing program until early 2014. But by Friday, the team changed its mind and released a new Fed call: “We now expect the Fed to announce tapering in December with the first rate hike to begin in summer 2015.”
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Advisors Fielding Client Calls
What has all this tapering talk and market madness done to financial advisors? It has left them fielding frantic requests from clients to tell them why the markets are gyrating wildly and what they’re doing to protect their portfolios.
“I never heard of the word ‘taper’ when I was studying economics in graduate school,” wrote Benjamin Hein, president and chief investment officer with PRS Investment Advisory, in a June 14 bond market update for the firm’s clients. “However, ‘tapering’ has become a buzzword of late with speculation regarding when and how the U.S. Federal Reserve will start reducing its purchases of fixed income securities, thus leading to potentially higher interest rates.”
Hein’s advice to fixed income investors is to take a second look at their portfolios and review with their financial advisors “whether some tweaking might be in order.” He believes that investors who have been piling into fixed-income funds over the past year will get a big wake-up call with their June statements, and he says the best way to play bonds these days is with diversified fixed-income portfolios that aren’t composed solely of high-quality securities.
“Of course, there is no guarantee that a diversified fixed-income portfolio will outperform a U.S. Treasury portfolio in a given month, but we believe that, particularly in today's low-interest rate environment, it is prudent to have exposure to a wide range of fixed-income and income-producing investments along with alternative investments to complement a pure fixed-income portfolio,” Hein writes.
In a comment describing “Why Bonds Still Make Sense,” New York-based independent investment advisory Gerstein Fisher reminds investors that the purpose of bonds in an investment portfolio is not to generate high returns — “the past 30 years notwithstanding” — but to dampen total portfolio volatility by balancing out riskier holdings such as equities.
“If you fear a rise in interest rates, one way to reduce your exposure to this risk would be to shorten the maturity or duration of your bond holdings from 10 years to five years or less,” Gerstein Fisher recommends, pointing out that shorter-duration bonds are less volatile. Alternatively, some investors may want to hold more cash, the firm says.
As for the stock market, Nuveen Asset Management chief equity strategist Bob Doll writes that U.S. equities declined last week as the S&P 500 ended down 2.09% and suffered its first back-to-back one-day declines of more than 1% since last November.
However, in his weekly investment comment, “The Fed Unintentionally Lays an Egg,” a bullish Doll asserts that a decrease in the Fed’s quantitative easing is not an economic hurdle.
“A diminished QE3 program should be expected, given slower growth of the federal budget deficit and the decrease in issuance of Treasury debt,” he writes. “Many have focused on the end of the great monetary experiment rather than the Fed’s message about its policy being data dependent. Potential outcomes may be either: 1) the economy will stabilize and allow investors to gain confidence in corporate earnings, or 2) soft and choppy data will persist, and QE will be extended.”
Investors Also Cautious on Equities, ETFs
While Doll remains bullish over a cyclical horizon, current conditions leave him cautious in the near term.
“The equity market has benefited from decent economic growth, moderating tail risk, depressed interest rates and low bond volatility,” he writes. “We maintain our positive views on equities cyclically, as bond yields remain well below nominal GDP growth, and profit growth should continue to be moderately positive. We expect overvalued, defensive sectors and bond proxies to bear the brunt of the position squaring. Conversely, we believe cyclical sectors are undervalued and earnings expectations are acceptable.”
Alec Young, global equity strategist with S&P Capital IQ, is not so bullish on the emerging markets.
Young’s international investment outlook on Monday notes that EM equities are nearing bear market territory, down 16.3% from their January 3 highs and 13.9% year to date, with widespread damage in emerging Asia, Latin America and emerging Europe, the Middle East and Africa suffering declines as high as 20%.
“We believe fears of receding central bank monetary policy accommodation are clearly the primary driver as EM volatility really accelerated right after Fed Chairman Bernanke’s May 22 press conference when QE tapering talk first started,” Young writes. “While we acknowledge that oversold EM assets are overdue for a counter-trend bounce, we believe the open-ended nature of the Fed tapering overhang will continue to limit rallies and fuel continued EM underperformance over the coming months.”
Many exchange traded funds also have taken a beating – though some ETFs still offer a safe haven.
ETFtrends.com web editor John Spence reported on Monday in “Treasury ETFs Continue Sell-Off as 10-Year Yield Climbs Above 2.6%” that the iShares 20+ Year Treasury Bond Fund (NYSEArca: TLT) traded lower again Monday after last week’s 5% sell-off when yields on the 10-year note broke through 2.6% for the first time since 2011.
“TLT and other Treasury bond ETFs have fallen sharply since the Federal Reserve said it could start pulling back on monetary stimulus if the economy improves,” Spence wrote.
Meanwhile, ETFtrends.com editor and owner Tom Lydon made an argument in favor of dividend ETFs in the face of market volatility.
“Treasury yields have spiked recently but solid dividend ETFs are still paying out more, which brings the focus back to dividend-yielding stocks, Lydon wrote in “Why Dividend ETFs Can Still Work,” published on Sunday. “Investors should look for dividend exchange traded funds that have potential for growth and the possibility to raise dividend payouts.”
Steve Doster, a certified financial planner with Doster Financial Planning in San Diego, said that he was hustling to get a client report done for a meeting on Monday afternoon because his clients are concerned about interest rates rising and their bond funds going down.
His job right now is to calm client fears.
“I'm a believer of the passive investment philosophy, so I continue to remind clients about the long-term horizon,” Doster wrote in an email. “And rising rates are a good thing for their long-term retirement plan even if there may be some short-term losses in their bond allocations.”
For direct insights on the role of ETFs in client portfolios from multiple experts—including Rick Ferri, Ron Delegge, Skip Schweiss and more—we invite you to register for AdvisorOne’s premiere advisorcentric Virtual ETF Summit, which starts July 23 (and get multiple hours of CFP Board CE).