It was the Federal Reserve policy statement heard ’round the world. On June 19, Ben Bernanke said that if America’s economic picture continued to improve, the Fed would reduce its third round of quantitative easing. Within two hours, the S&P 500 fell by 1.3%. By the next Monday, the market was down 5%. Many other indexes around the globe fell as well.
Investors reflexively fear change, but many experts believe they overreacted in this instance. The tapering off of asset purchases—the Fed has been buying about US$85 billion in bonds every month—means the economy is improving and no longer in need of artificial life support. Many investors were no doubt anticipating the Fed’s eventual next step: raising interest rates. But the last thing investors should do during this inevitably volatile adjustment period is panic. According to Pavilion Investment House, a Montreal-based wealth management firm, during the three months after a rate hike the S&P 500 falls, on average, by 1.4%. But after 12 months it’s typically up 4.7%.
One caveat is that the type of quantitative easing we’ve witnessed over the past few years is unprecedented. Predictions based on previous tightenings in short-term interest rates may not apply. Still, Pierre Lapointe, Pavilion’s head of global strategy and research, says “the market is doing exactly what it usually does.” His overall message is to hang on and stay invested. But because a stimulus withdrawal will affect different parts of the market differently, you may want to make a few tweaks to your portfolio in the coming months.
After the recession hit, the Federal Reserve began buying mortgage-backed securities and treasury bonds in an attempt to lower interest rates and spur the economy. There have been three rounds of quantitative easing, or QE. The first two, in 2008 and 2010, had end dates. The most recent round, which began last September, was left open-ended pending a self-sustained recovery.
The world will spend the next several decades debating whether QE spurred the economic growth the Fed hoped it would, but one thing’s for certain: keeping interest rates artificially low for so long was effective at luring investors into stocks. Since bond rates were so low (the 10-year treasury bond bottomed out at 1.6% earlier this year) the only place to get a decent return was in equities—dividend-paying and emerging-market stocks in particular. “It helped push people from safe assets into risky assets,” says Patrick O’Toole, CIBC Global Asset Management’s vice-president of global fixed income.
A secondary effect of the low rates was that within the retail bond market, money flowed away from the lower-yielding government bond funds, and toward higher-yielding corporate funds and balanced funds, which hold both stocks and bonds.
As the QE stimulus winds down, it’s likely that in the short term, bond and equity markets will experience some ups and downs. Long-term bond yields are rising; at the time of writing, the 10-year U.S. treasury yield was about 2.6%. That means bond prices are falling, so if you bought fixed income over the past few months, you’ve likely lost some money. However, O’Toole points out that rates aren’t increasing dramatically, so the loss will be modest.
David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates, points out that bond yields are simply rising to where they should be. “People have been lulled into the sense that below 2% on a 10-year note is somehow normal,” he says. “The reality is that at the worst part of the recession, the 10-year note was trading at 3.25%.” He thinks yields will return to around 3%, which is where they’d likely be if the Fed hadn’t got involved.
Equity markets are undergoing a normalization period too. Some of the money that went into dividend-paying stocks will work its way back into bonds. Rosenberg suggests looking at 1993 and 2003, when bond rates had bottomed out, as examples of where the market might go. Back then, bond yields started to rise in anticipation of a hike well before it actually happened. The market was “wobbly” for a while, says Rosenberg, but started climbing after it was clear the economy was on the mend.
It’s a similar story today. Many worry that once the stimulus ends, the country will have another setback, says Lapointe. But economic data is more positive than it has been in years. Job growth and the rebound in the housing market signal that the worst is over. Lost in the noise was the Fed’s statement that it won’t reduce its asset purchases if that improvement stalls. Plus, the pullback will be gradual. While Bernanke offered no timetable, many people think the Fed will reduce its purchases to US$65 billion a month by the end of the year and then turn off the taps altogether sometime in 2014. Should the economy continue to recover, company earnings will improve, and that will buoy the stock market. “It’s all about earnings,” says Lapointe. “And they are on an uptrend.”
To prepare for the transition, investors should consider moving money out of interest-rate-sensitive sectors such as utilities, REITs, telecoms and some consumer staples stocks, and into more cyclical sectors, says Rosenberg. The reason is twofold: as bond rates rise, people tend to move out of dividend-paying equities and into less risky fixed income. As well, when the economy improves, growth stocks tend to outperform.
Going forward, Craig Basinger, Macquarie Private Wealth’s chief investment officer, likes some consumer discretionary sectors, such as automakers and forest companies, that have exposure to the U.S. housing rebound. Lapointe is looking at discretionary and industrial stocks, while O’Toole and Rosenberg think financials are a good bet. The latter sector pays attractive yields, but these companies also benefit from rising rates. Insurance companies can make more on their annuity product liabilities, while banks will make money on consumers borrowing at higher rates.
Perhaps the best advice right now is to look for good deals while the market works itself out. “All of this volatility presents a buying opportunity,” says Lapointe. “People shouldn’t worry—the Fed will not stop QE unless the economy is in great shape.”