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Global Investment Strategy

July 27, 2015 (Weekly Update)

Chris Haverland, CFA, Global Asset Allocation Strategist

Weekly market insights from the Global Investment Strategy team

  • We expect the Federal Reserve (Fed) to begin increasing the federal funds rate in September or December.
  • Early Fed rate hikes typically create some volatility in financial markets, but do not signal a looming recession or the end of an equity bull market.

What it may mean for investors

  • Not all asset classes will respond in a similar fashion. Therefore, it is critical to remain diversified during Fed tightening periods and to employ a tactical asset allocation strategy.

Fed Tightening and Asset Class Performance

As we approach the first Fed rate hike in several years, investors may be concerned with how it will impact individual asset classes, as well as overall portfolio performance. Even though economic data has been less than spectacular this year, we continue to believe the Fed will raise the fed funds rate at least once in 2015 (starting in September or December). We expect the Federal Open Market Committee (FOMC) meeting announcement later this week to lay the groundwork for an increase later this year as the employment situation appears to be on solid footing and inflation is firming, especially at the core level. Meanwhile, geopolitical concerns, which have been at the forefront in recent months, have ebbed, likely giving the Fed an all-clear to begin its latest tightening cycle. We believe timing is less important than magnitude and pace. Our view is that any rate increases will be well-telegraphed and measured.

How will the initial Fed rate hike impact asset class returns? This is a common question among investors because some see higher rates as a negative for financial market performance. In recent equity reports we have highlighted U.S. large-cap performance during Fed rate hikes and noted, in most cases, returns are positive one to two years after the first rate increase. It is important to keep in mind that early Fed rate hikes typically do not signal a looming recession or the end of an equity bull market. Once investors adjust to higher interest rates, the markets have historically responded positively (especially when the Fed’s actions are due to stronger economic data).

Not all asset classes respond to moves in interest rates in the same way. Bonds, as a rule, are the most sensitive; however, stocks with high dividend yields may also experience volatility as bond yields become more competitive. In general, equities historically have shown resilience in the face of Fed tightening, leading most asset class returns after liftoff. International markets may be more impacted by their own economic and business conditions than by changes in U.S. interest-rate policy, but they too, typically have appreciated during U.S. rising-rate environments. Finally, hedge funds often can take advantage of an environment of rising yields, increased volatility, and lack of liquidity. In particular, Macro strategies may benefit from trends in global assets responding to an increase in interest rates, while Relative Value strategies can provide exposure to fixed income and credit with less sensitivity to interest rates.

Chart 1. 12-Month Returns Following First Fed Rate Hike (1994, 2004) Chart 1. 12-Month Returns Following First Fed Rate Hike (1994, 2004)
Source: FactSet, 7/24/15
An index is unmanaged and not available for direct investment.

Looking at the last two low-rate environments when the Fed began to raise rates (1994 and 2004) we see a mixed bag from a performance perspective. The starting fed funds rate in 1994 was 3.00 percent, and the Fed increased rates by 300 basis points in a little over a year. This weighed heavily on many risk assets with real estate investment trusts (REITs) and emerging-market equities posting double-digit losses over the first 12 months. 2004 is probably the closest example to today’s rate landscape, and the path to rate normalization likely will be similar. The starting fed funds rate in 2004 was 1.00 percent with the Fed gradually raising rates over a multi-year period. Financial markets responded favorably with 12- and 24-month returns positive for all asset classes.

What should investors do with a Fed rate increase looming? If you have a diversified portfolio, we suggest maintaining your strategic allocations and employing our tactical guidance as we enter the next fed funds rate cycle. History can give us a directional guide of market performance once the Fed raises rates. However, the economy and financial markets are more globally intertwined than in the past and could react differently this time around. Our view is that the Fed will be very cautious on the path to rate normalization. Although any change in policy is likely to create volatility, it is unlikely to have a meaningful long-term negative impact on asset prices.

Chris HaverlandAbout Chris Haverland

Chris Haverland is a global asset allocation strategist for Wells Fargo Investment Institute (WFII), an organization that provides global manager research and investment strategy advice to Wells Fargo’s Wealth, Brokerage, and Retirement (WBR) division. WBR is comprised of Wells Fargo Private Bank, Wells Fargo Advisors, Wells Fargo Institutional Retirement, and Abbot Downing businesses, accounting for more than $1.6 trillion* in assets under administration.

Mr. Haverland is responsible for thought leadership on the economy, financial markets, investment strategy, and asset allocation. He researches timely investment topics and produces market updates, special reports, white papers, podcasts, and webcasts that articulate strategies for clients that help them meet their long-term financial goals. Other responsibilities include developing capital market assumptions and strategic asset allocations, providing tactical advice, conducting asset class research, assisting in portfolio management, writing commentary for investment publications, and providing investment guidance for financial advisors and clients.

Prior to joining Wells Fargo, Mr. Haverland was a portfolio manager, corporate bond analyst and trader at Jefferson Pilot Financial (now part of Lincoln Financial) in Greensboro, North Carolina, where he managed $2.6 billion in fixed income assets. He has nearly 20 years of experience in financial services.

Mr. Haverland earned a Masters of Business Administration from Elon University and a Bachelor of Science in Business Administration from Appalachian State University. He is a CFA® charterholder and is a member of the CFA North Carolina Society. Mr. Haverland is located in Winston Salem, North Carolina.

*As of Sept. 30, 2014

Risk Factors

Asset allocation does not guarantee a profit or protect against loss.

Disclaimers

Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the Global Investment Strategy division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

Wells Fargo Advisors is registered with the U.S. Securities Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.

Brokerage products and services are offered through Wells Fargo Advisors. Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company.

 
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