ETFs Waiting for Signs on the Fiscal Cliff and Fed

ETF Trends

Investors are stuck between a rock and a hard place: They’re trying to plan for the end of 2012, while also looking ahead to 2013. It’s being reflected in the questions I’m getting from clients right now, who are worried both about the fiscal cliff and the outlook for interest rates in 2013

As we saw last week, the markets are focused on every utterance out of Washington on the fiscal cliff. For better or worse, this is unlikely to change until we have a deal. And in terms of getting to one, the truth is we did not see much progress last week.

Moreover, it is important to note that, while investors are focused on getting something done by year’s end, a more important deadline may be Christmas Eve. There are roughly 80 Congressman and Senators who will not be returning to Washington next year and many of them plan to leave before the holiday, suggesting that a deal has to be in place by the 24 th . That means the parties are going to need to start to move if a compromise is to be reached in time.

Meanwhile, indicating that some investors are looking past December 31 st , I’ve been getting a lot of questions on what to expect from the Federal Reserve in 2013. In short, clients are asking about the future direction of monetary policy and when the Fed might raise interest rates.

To answer that question, investors should focus on the labor market, since it is important to remember that the Fed has a dual mandate: keep prices stable, but also maximize employment. Given that the Fed is not particularly worried about inflation, changes in the labor market are likely to be the key driver for any change in monetary policy.  As a rough rule of thumb, then, investors should assume the following:

1.)  The Fed is likely to end quantitative easing before they start to raise rates.

2.)   In terms of when that is likely to happen, look for unemployment to drop down closer to 7%. It will probably take a further drop to around 6.5% before the Fed is likely to start raising interest rates.

3.)  Given the speed at which the unemployment rate is dropping, we’re probably looking at the back half of 2013, at the earliest, before we’re likely to see an end to the Fed’s asset purchases, and even longer before short-term rates are likely to rise.

Bottom line — unless we start to see the US economy producing at least 200-250k jobs a month, the unemployment rate is likely to fall very slowly. That means that the Fed will likely keep rates low and further expand its balance sheet for the foreseeable future.

For investors who need income in this environment, we would continue to advocate equities and credit, rather than duration.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock.

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