SPDR ETFs : End of an Era: Positioning Portfolios for Higher Interest Rates

The wait is finally over. The Federal Reserve (Fed) has raised rates for the first time in nearly 10 years, removing a pivotal piece of monetary policy left over from the financial crisis……

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David B. Mazza – Vice President of State Street Global Advisors and the Head of Research for SSGA’s ETF and mutual fund businesses

By instituting a rate hike that decouples US monetary policy from the rest of the world, the Fed is demonstrating its confidence that the economic recovery remains on track even in the face of domestic and global headwinds, including a strong US dollar and a slowdown in global manufacturing.

In taking action now, the Fed is also attempting to avoid delaying a rate hike for too long and then finding itself in the position of having to abruptly raise rates. Fed Chair Janet Yellen has acknowledged that abrupt tightening could risk disrupting financial markets and possibly push the economy into recession.1

At State Street Global Advisors (SSGA), we think this decision could trigger periods of volatility and a short-term market sell-off as investors digest the news and reposition for a new interest rate climate. Our view is that this rate hike will be followed by a series of four quarter-point rate hikes in 2016.

Rate rise notwithstanding, the US remains in an accommodative environment, and we expect it to remain so for the foreseeable future. The Fed’s path to rate normalization should be a slow and gradual one that will be supported by labor market improvements and rising inflation. SSGA believes investors would be well served to take a long-term view and construct a diversified portfolio that’s positioned to benefit from a continued US economic recovery.

Volatility ahead: Managing fixed income portfolios

In the short term, we expect volatility in the fixed income markets, from treasuries to credit, as investors attempt to gauge the impact of the Fed’s move on the yield curve and the health of corporate balance sheets for some of the more indebted firms.

Historically, studies have shown that asset allocation accounts for approximately 90% of the variation of all returns. As a result, the Fed’s actions afford investors the opportunity to reexamine and reallocate their portfolios across all asset classes, including fixed income, to address the new era of US monetary policy.2

Rather than indiscriminately selling long-dated exposures or relying on a broad fixed income benchmark like the Barclays U.S. Aggregate Bond Index, investors may want to consider integrating certain exposures, like the three below, which may help diversify a portfolio’s interest rate risk profile without sacrificing yield:

   An active core fixed income strategy with experienced managers may play a critical role in providing a portfolio with stability, diversification and income. Investors seeking an actively managed core solution for their fixed income portfolio can consider the SPDR® DoubleLine® Total Return Tactical ETF [TOTL]. TOTL strives to outperform the benchmark by exploiting inefficiencies within subsectors of the fixed income market, while maintaining active risk management constraints.

   Short-term investment-grade floating-rate notes and senior secured loans that feature a low duration profile and floating coupons. Solutions such as the SPDR Blackstone/GSO Senior Loan ETF [SRLN] and SPDR Barclays Investment Grade Floating Rate ETF [FLRN] may provide attractive options for such an exposure.

   Convertibles, such as the SPDR Barclays Convertible Securities ETF [CWB], may offer diversification benefits as well as income opportunities.

Sectors and Industries for modestly rising interest rates

Anticipating that the Federal Reserve would hike rates this year, we have seen investors transitioning their equity holdings into sectors and industries that are geared for a continued US economic recovery.

Historically, while a rising economic tide tends to lift all sectors to some degree, we believe the consumer discretionary and financial sectors will likely benefit most in this stage of the recovery.

Among industries, investors may consider:

   Homebuilders: The US labor market continues to strengthen as the unemployment rate has dropped to 5.0%.3 The strong employment backdrop has buoyed homebuilder sentiment4 and housing demand.5 Incorporating discretionary housing industries, such as home improvement and furnishing retail, and expanding beyond concentrated positions in new home construction firms is the preferred approach to capturing the full effects of this bourgeoning housing market. Consider accessing the asset class through the SPDR S&P® Homebuilders ETF [XHB].

   Regional Banks: The early part of the tightening cycle is especially constructive for banks, as higher rates create more room to increase margins on their loans without stifling demand. Regional banks typically engage in commercial lending, and an improving economy will entice businesses to increase their borrowing to finance growth. To the degree the Fed’s move reflects its confidence in the economy, we’d expect lending activity to respond positively. This trend is already emerging as the availability of credit for US small businesses improves, with conditions now at pre-recession levels.6 US consumer credit is also improving, and consumer loan balances, excluding government-held student loans, have exceeded their 2008 peak.7 Investors may access this opportunity through the SPDR S&P Regional Banking ETF [KRE].

The takeaway for investors

While volatility could remain elevated, it’s important to remember that investors have successfully weathered rising rate environments in the past by keeping an eye on asset class allocation and regularly rebalancing portfolios.

For 2016, SSGA anticipates a continuation of the “low and slow” growth environment that has characterized the global economy since the financial crisis. While US economic growth has slowed, there are reasons to be optimistic. The US consumer has been incredibly resilient, with job growth and the housing market trending in the right direction. It’s hard to argue the US will slip into a recession with these conditions in place—a sentiment Yellen also echoed in recent Congressional testimony.”


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