The Federal Reserve (Fed) has extended its “zero interest rate policy,” keeping rates at historically low levels as it assesses how slowing growth in China and a stronger US dollar may impact inflation and the pace of the US economic recovery.
Despite market volatility and worries over China, recent US economic data is pointing to a sustained recovery.1 Once the Fed is comfortable that core inflation is also moving toward its 2% target, we believe a rate hike is more likely.
Market volatility across asset classes is likely to increase as investors closely scrutinize upcoming economic data releases to determine when a Fed liftoff may occur. To prepare for the rate hike, investors should consider constructing a diversified portfolio that’s positioned to benefit from a continued US economic recovery.
Data points to sustained US economic recovery
The Fed has said it will be data dependent in deciding when to end its near-zero interest rate policy, and a number of Federal Reserve officials have indicated the economy is strong enough to handle a quarter-point rate increase.2
In the US, household formation, labor growth and consumer sentiment have all trended higher.3 While China’s growth may slow, there has never been a global recession without a US recession, and US recessions have not historically occurred when the labor market is improving and consumers are buying homes.
When the Fed does begin raising rates, its path toward “normalization” should be slow and gradual. The US economy has never been in a zero-rate environment for this long, nor has it relied so heavily on quantitative easing. Once rates are raised, we believe the Fed is not likely to follow a traditional path of increasing rates a quarter-point at each meeting. Instead, it may carefully evaluate future increases against new economic data that points to labor market improvements and rising inflation.
The market consensus is that by the end of this year there will be a 50 basis point increase in the benchmark federal funds rate.4 While the Fed was dovish in September, it doesn’t mean it cannot be hawkish by Halloween with a rate hike at the October meeting.
Considering asset allocation explains approximately 90% of the variation of all returns, the Fed’s delay affords investors the additional opportunity to reexamine and reallocate their portfolios─from bonds to stocks to commodities─ahead of this consensus-viewed tightening cycle.5
Look Beyond the Barclays Agg for Bonds
Rather than relying on a broad fixed income benchmark like the Barclays U.S. Aggregate Bond Index, which has a relatively low yield per unit of duration risk, and represents a narrow slice of the overall bond market, integrating certain fixed income sectors may help diversify a portfolio’s interest rate risk profile without sacrificing yield. Here are three to consider: