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Why rising rates are actually good news for investors

U.S. Federal Reserve is signalling the first interest rate hike since 2006 – it shows the economy is improving, corporate profits are rising and investors can expect steady market conditions

By: SIMON AVERY

Date: November 13,2014

Now that the Band-Aid has been ripped off, what’s the patient to do?

The U.S. Federal Reserve is setting its sights on the first interest rate hike since 2006, after terminating its two-year, $1.6-trillion (U.S.) stimulus program at the end of October.

Many economists and professional money managers have expected for a while that the rate increase will come by the middle of next year. But there is new speculation it could come earlier, following the Fed’s statement that the U.S. employment market is healing. For the retail investor, the precise timing is much less important than having a strategy suited for the new environment.

The Fed’s conclusion of its third bond-buying stimulus program, together with its new tone on rates, amounts to a “regime shift” in monetary policy, says Jurrien Timmer, director of global macro for Fidelity Investments in Boston.

Since launching its first quantitative easing program in 2008, followed by two further rounds, the U.S. central bank has spent more than $3-trillion on stimulus, helping to inflate the price of stocks, bonds and other assets in the process. During the same period, the Fed has held its benchmark interest rate at zero to 0.25 per cent.

Economists and money managers have warned for a long time that exiting this unprecedented period of loose monetary policy could rock both the bond and stock markets. So far, however, the markets have digested the news in stride, acknowledging that stimulus is no longer necessary and that rates will need to rise, Mr. Timmer says.

“[North American] investors shouldn’t do anything differently right now,” he says. “The U.S. economy does appear to have reached a point of self-sustaining momentum.”

With growth “humming along” at a moderate level and no significant signs of inflation in sight, investors can expect steady market conditions, he said. That includes a very gradual increase in rates over the next few years, which should top out close to 3 per cent, rather than the historical norm of 5 per cent. As long as the U.S. economy doesn’t unexpectedly overheat, the Fed can stick to the roadmap it has telegraphed and maintain the confidence of investors, he added.

“That means investors should stick with their current plans,” Mr. Timmer says.

Many people are concerned that anemic growth rates in Europe and Japan, as well as the end of China’s hyper-growth phase, spell bad news for North American stocks. But economic troubles around the world are most likely to act as a dampener on U.S. growth, keeping inflation and markets in check, he said.

Rising rates are actually good news for investors for two reasons, says Adrian Mastracci, portfolio manager with KCM Wealth Management Inc. in Vancouver.

First, they signal an improving U.S. economic outlook, which supports rising corporate profits and stronger balance sheets. “Investors will be worse off if interest rates stay at current levels for an extended period. It means that the global economic recovery is in doubt,” he said.

Second, higher rates will mean larger yields, which will help investors who are looking for low-risk ways to generate income. At the moment, Government of Canada 10-year bonds are yielding just 2 per cent while the 30-year notes offer 2.6 per cent. After factoring in inflation and taxes on the interest, the return is negative, Mr. Mastracci says.

Mr. Mastracci advises investors to move their government bond holdings entirely to short-term notes with durations of no more than five years. He also suggests a mix of sovereign and high-grade corporate bonds to improve returns.

In terms of strategy, rising rates demand that investors “revisit their appetite for risk.” This means asking themselves, what is their ability to take risks when considered next to their investment timelines. And also, what is their need to take risk measured next to the rate of return required to achieve their goals.

As an example, he points to the strong stock market returns over the past five years. The gains mean that for many investors the value of their portfolios is now weighted more to equities than they initially planned. Are you “truly comfortable with risk if equities exceed 60 per cent of [your] total portfolio?” he asks.

As rates look to rise, Mr. Timmer says he remains a strong believer in U.S. government bonds, noting that they are cheaper than almost all other sovereign bonds in the industrialized world. “There is too much capital around the world and it’s flowing into U.S. bonds,” he says.

There is no reason to sell these bonds today, he adds, because as the coupons get paid they can be invested in higher yielding notes. “If rates go up gradually, you can still make money in bonds,” he says.

In terms of equities, Mr. Timmer remains bullish on U.S. stocks, even though they look expensive compared with historical norms.

In Europe, the central bank is heading down the opposite path of the Fed, promising greater stimulus in the months ahead as a means to spur growth and modest inflation. But Mr. Timmer says that with low growth, high unemployment and a falling currency, Europe has nothing to offer investors over the United States, even though its stocks look cheaper.

“The U.S. is the best house on the street and usually the best house sells for more than the others,” he said. “I don’t see a lot of reason right now to leave the home base.”

He recommends that investors focus on sectors with a strong domestic market, namely health care, technology and finance. As interest rates advance, the market is going to favour companies with stable earnings and forecasts, which suggests that large cap stocks will prove a good place to be, he said.

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