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These Are The ETFs To Own As Fed Raises Rates

Scott Kubie

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief strategist of Omaha, Nebraska-based CLS Investments.

This past May 18 stands out among trading days. It was special because a minimal number of variables affected markets.

On that day, the Federal Reserve dominated the news by finally convincing investors to raise their expectations (at least temporarily) for a rate hike in June or July. British polling data released the same day showed polls trending against the Brexit. And that was about it.

Rarely does one day provide such clarity regarding how asset classes were influenced by expectations of rate hikes from the Federal Reserve. The performance that day also gives insight into why bonds have performed well since the first rate hike, and how market expectations would need to adjust if the Fed follows through with two hikes and the economy continues to improve.

How Many Hikes Do You Have In You?

Investors anticipated the Fed would continue to lower expectations for rate hikes toward those reflected in the futures market. As many have noted, investors pushed prices for long-term bonds higher after the sole Fed rate hike last year. Investor reaction since the last hike communicated to the Fed that it made a mistake that will need to be reversed.

This view prevailed until the Fed, in the minutes from its last meeting, expressed disagreement with this reasoning by pointedly raising expectations for how quickly rates will increase.

Even after the terrible job numbers on June 3, 2016, I believe the Fed will raise rates twice by the first meeting of next year. Market-implied expectations reflect deep uncertainty. Odds for one hike remain above the odds for two hikes. The odds for no hikes in 2016 remain fairly high as well. This was even truer in mid-May, when the Fed released minutes that deliberately pushed investors toward its point of view.

While Fed decisions affect almost every asset class, the performance on May 18, 2016, helps identify those asset classes likely to be affected positively and negatively by a rate hike and the linkages between them. One of our top ETFs in recommended asset classes is included.

Fixed Income

Bonds did not welcome the news of potential hikes. The performance graph below shows a decline in longer-duration assets. The Federal Reserve minutes communicated two powerful messages. First, investors are underestimating the willingness of the Fed to raise rates. Second, investors are underestimating how quickly economic gains are removing slack from the economy.

On May 18, long-term Treasury bonds, such as the iShares 20+ Year Treasury Bond (TLT | A-83), lost more than 1.5%. TIPS and seven- to 10-year Treasury bonds reacted poorly. Some had predicted continued yield-curve flattening, but may have misjudged how small increases in yield can swing prices of high-duration securities.

Investors should focus on short-duration TIPS (the PIMCO 1-5 Year US TIPS Index ETF (STPZ | A-74)), and use very small positions in long maturities (TLT) and areas where the yield curve is steep (the iShares 3-7 Year Treasury Bond ETF (IEI | A-73)), to supplement returns.

Currency

The dollar rallied sharply on the news. Higher expected rates in the future made the dollar a more attractive currency to hold. The decline in the dollar since the last hike matches the decline in long-term interest rates. The market’s reaction implies a collective view that the Fed’s moves are likely to stall or be reversed because it moved too early.

The British pound rallied on news of polls suggesting the “Brexit” is less likely. Investors should continue to hedge international bond exposure (the Vanguard Total International Bond Index ETF (BNDX | B-57)), and consider marginally increasing currency hedging in international equities, the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF | B-74).

Commodities

Most commodity positions fell on the news. Higher rates challenge commodities because the future returns of bonds increase as rates rise. The move in commodities also reflects the effect of a dollar increase. When the dollar rises, it is quite possible for commodity prices to fall in dollar terms, while rising in euro terms.

While the market reflects a high conviction that one or two hikes make a big difference, I hold to the view that the next few hikes will do little to slow the economy. Rather, they might speed it up by normalizing the economic environment and signaling expected economic strength.

Investors should continue to favor commodities—the PowerShares DB Optimum Yield Diversified Commodity Strategy Portfolio (PDBC | B) or the iShares Commodities Select Strategy ETF (COMT)—in spite of the short-term negative reaction.

International

Latin American stocks can be in the sweet spot or the bull’s-eye, depending on how economic trends shape expectations.

The Federal Reserve’s minutes put it firmly in the bullseye, because the three previous reactions all negatively affect Latin American stocks. Rising rates in the U.S. move Latin American rates higher in order to maintain the spread between the two areas. Higher rates pressure stocks by requiring a higher rate of return.

Latin American countries and companies often issue dollar-denominated debt but earn profits in different currencies. A strong dollar increases risk and financing costs. Latin American economies produce a wide range of commodities for export. Lower commodity prices pinch profits a third time. Given this triple threat, it is no surprise Latin American stocks lagged on the day of the announcement.

Instead, investors should favor European stocks (the Vanguard FTSE Europe ETF (VGK | A-97)), and Japanese stocks (the iShares MSCI Japan ETF (EWJ | B-95)). Those countries prefer a lower currency, issue debt in their own currencies and generally import commodities. As mentioned earlier, hedging some of the position makes sense.

Sectors

Utility stocks, loved for their dividends, were the worst-performing sector on May 18. The competition from higher-yielding bonds requires a high-yielding stock, pushing prices lower. Utilities often leverage the balance sheet more than most companies. Increasing rates imply higher costs for debt, ultimately affecting profits.

In contrast, financials—the Fidelity MSCI Financials Index ETF (FNCL | A-96), the day’s big winner—benefit from normalizing rates supporting their business model of paying savers and lending at higher rates. A steeper yield curve and mildly positive saving rates benefit banks’ business.

Conclusion

There are two primary conclusions I draw from this research.

First, investing in a slower-growth environment fraught with crises raises the importance of policy to the markets. While we can’t know for certain how policy will evolve, tilting your portfolio toward one of the outcomes may make sense.

Second, make sure you are really diversified. A portfolio invested in long-term bonds, international bonds, commodities, utilities and Latin American stocks sounds pretty diversified. Yet each of those asset classes becomes less attractive if the Fed raises rates more than expected. Investments a world apart can easily move in tandem.

At the time of writing, CLS clients owned FNCL, VGK, EWJ, COMT, IEI, STPZ, TLT, DBEF and BNDX. CLS Investments is an Omaha, Nebraska-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Chief Strategist Scott Kubie at 402-896-7406 or at scottk@clsinvest.com. Please click here for a complete list of relevant disclosures and definitions.

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