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As Markets Falter, Stay Diversified

Linda Bakhshian

It's possible the past week was a nervous one for many long-term investors, perhaps even echoing the dark days of 2008 when it seemed there was no place to hide. Treasuries sold off. Domestic stocks sold off. Global stocks sold off. It seemed, in other words, as if everything was falling.

It's never fun when the party begins to end, and that's what Federal Reserve policymakers and Chairman Ben Bernanke seem to be signaling -- not taking away the punch bowl, necessarily, but spiking it a lot less. Indeed, it seems Bernanke was clear that the current thinking among policymakers is data dependent -- meaning when and how much to taper Fed bond buying will be a fluid decision and that the "last call'' won't come for some time -- and that 2015 remains the current consensus for the central bank to begin actually tapping on the brakes by raising the benchmark funds rate.

Still, the revelation that the days of quantitative easing really are numbered sent Treasury yields spiking and equity markets plunging. But let's put this into perspective. Why would the Fed feel compelled to start easing off the monetary accommodation now? It could be that the size of its balance sheet is getting too big, or maybe it wants to clear the stage before turning over the reins to the next potential new Fed chair in 2014. Or it could be the Fed simply expects the economy to be strong enough not only to stand on its on, but to grow fast enough to put it on a path to reach the Fed's two preferred thresholds -- an unemployment rate of 6.5 percent or lower, and inflation of about 2 percent to 2.5 percent.

If anything, the Fed's faith in the economy should be good news for much of the investment world. But as almost always is the case when the Fed signals a potential change in its stance, the equity and bond markets reaction was to sell first, ask questions later.

I'm betting once the markets emerge from their disappointment that the liquidity party won't last forever they'll turn their attention to what has been left in the wake of five years of unprecedented Fed stimulus: an economy that has healed enough to grow on its own -- without stimulus. History tells us such an environment tends to be good for growth and earnings, and thus for stocks.

But while stocks and commodities tend do better than fixed-income assets when a rising-rate environment is driven by healthy economic growth, there are opportunities in the bond world, as well. Bonds that are more sensitive to the economy -- so-called high-yield corporate bonds that in some ways behave like equities because their value is aligned with corporate performance -- also tend to outperform Treasuries and mortgages when the economy is in decent shape.

And despite their current weakness, international bonds, primarily those issued by emerging-market countries whose economies depend on global trade, also historically tend to perform better than U.S. government issues for similar reasons during periods of rising rates.

So what should an investor who needs current yield do in face of such volatility within the markets? Diversify into the more interest-rate and economically sensitive portions of the equity and bond markets. Rising rates will favor certain sectors versus others, and certain bond classes versus others.

For 2013, higher anticipated yields driven by growth and policy expectations rather than inflation concerns should lead to higher equity valuations, strength in cyclical sectors and better corporate performance versus government bonds. Cyclical areas of the market include technology, energy and even some financial companies, all of which may benefit from rising rates more than utilities, telecom or consumer staples sectors.

Don't just buy yield. Investors at this point in the cycle also should look for a balance of dividend yield and growth -- maybe tilted more towards dividend growth. Look for companies that have more leverage to the underlying economy, meaning as economy steadily improves, these companies should exhibit relatively stronger and healthier corporate cash and profitability.

In general, ex-U.S. companies tend to pay higher yields, so look for same balance of yield and dividend growth backed by improving fundamentals, cash flows and balance sheets in international companies as well. The added complexity of international investing comes from having to do more work on where you're investing; in other words, look at countries with strong current and projected economic growth.

The bottom line: for long-term investors, diversifying across asset classes and geographic boundaries at any time, particularly during periods of rising rates, can improve the opportunities to capture yield and improve returns without unduly increasing the potential exposure to risk. This is worth remembering in this era of the 24/7 news cycle that, with its instantaneous and sometimes sensationalized analysis, spawns overreaction and undue consternation.

With more than 14 years of investment experience, Linda Bakhshian co-manages the Capital Income Fund, Equity Income Fund and Muni Stock Advantage Fund at Federated Investors. Linda is a CPA and a chartered accountant. She earned a bachelor's degree from the University of New England (Australia).

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