As we begin the first leg of an interest rate hike cycle, I am pleased to report that most portfolios outperformed both the broad market and their peers in 2015, net of fees. I attribute our success to diversification, sector selection and low fees.
The High Risk portfolio returned 3.91%; the Mod-to-High Risk portfolio returned 3.99%; the Moderate portfolio returned 1.55%; and the Low Risk portfolio returned 0.30%.
In comparison, the S&P 500 returned -2.19%, and the Vanguard Institutional Index (S&P 500 with dividends reinvested), returned 1.39%.
After seven years of holding short-term rates at zero, the Federal Reserve raised interest rates in December. Investors had eagerly anticipated the rate hike since it usually signals continuation of a bull market.
However, stocks have dropped and appear to be on the brink of another correction. Intermediate and long-term interest rates have also dropped. These trends are confusing to investors and advisors alike.
Fortunately, I have done a considerable amount of research into how markets move following a rate hike, and which sectors tend to perform well based on the direction of the U.S. dollar. Implementing the results from my in-depth research should continue to drive above average returns while minimizing volatility.
You may be surprised, but I believe long-term interest rates will fall in 2016. This is because long-term rates do not directly correlate with short-term rates. In the past three interest rate hike cycles, long- term rates actually fell.
While the Federal Reserve will likely continue to raise short-term interest rates in 2016, long-term rates will move more in-line with the market. As the market continues to stumble due to a strong dollar, investors likely will turn to bonds. This will drive long-term rates down.
How low rates will fall is unknown. Those still looking to buy a home, refinance their home, convert variable debt to fixed rate debt, or looking to take advantage of a lump sum rollover of their pension will find this news encouraging.
What investors will not find encouraging is that equity returns could stagnate for another year or more. Many experts are now predicting stocks will perform worse this coming year. Some are even saying there is going to be a market crash as the economy comes down from its “Fed-induced high.”
While I believe the odds of another 2008 are low, the greatest headwind to equities and the basis for many of these claims is the appreciating U.S. dollar.
When the U.S. dollar appreciates, equities become very volatile. The dollar has been appreciating due to the overall strength of the U.S. economy, as well as other industrialized nations’ engagement in economic policies seeking to devalue their currency against the U.S. dollar.
Much of this volatility stems from the fact that a strong dollar reduces corporate earnings. Weak or weakening earnings lead to increased volatility and falling stock prices. In late 2015, earnings began to fall as the dollar continued to rally, which ultimately led to two market corrections.
The theme of 2015 was rising interest rates and the effects rising rates have on bonds. The bond allocation in all portfolios was not immune; bond values dropped. Fortunately, due to the low duration focus and hedged positions, losses were minimized.
Over the past two years, the bond allocation was invested in low duration bond funds. Duration, expressed in years, shows how sensitive a bond fund is to rising interest rates. The lower the duration, the less a bond fund is affected by rising interest rates. The decision to invest in low duration bond funds is the reason losses were minimized as interest rates rose.
In late 2015, the long-term bond position, which had been allocated to a senior floating rate bond fund, was shifted to an inverse government bond fund. An inverse bond fund is one that appreciates as interest rates rise. This move was done to hedge the effect of rising interest rates on the bond allocation.
The shift to an inverse bond fund helped minimize losses of the other bond funds because the trade generated a positive return. Based on technical analysis, there appears to be a bit more upside in this position. Once technical indicators suggest long-term rates have peaked, this position will be swapped for a traditional long-term government bond fund that appreciates when long-term rates fall.
Intermediate Term Bonds
This position remains in a low duration bond fund as intermediate term rates are expected to continue to rise. Even though the total return was negative last year, the loss was minimized due to the low duration focus. Technical analyses suggest that intermediate term rates are also approaching a peak. This foreshadows a downturn in equities and a potential opportunity to increase duration at some point this year.
High Yield Bonds
High yield bonds have a significant degree of correlation to equities. In late 2015, high yield bonds dropped. This resulted in two predictable market corrections.
While this position was negative last year, low duration focus minimized the loss. There is opportunity in this position. Technical analyses suggest high yield bonds are at a long-term low point. This means an increase in duration could lead to higher returns once equities rebound. Adjustments will be made to this position to take advantage of a market rebound when the opportunity presents itself.
The actions of the Federal Reserve have driven short-term rates up, which has been bearish for short- term bond funds. The current fund has performed very well due to the low duration focus and has only taken a small loss. Presently, there is no reason to replace this fund.
Emerging Market Bonds
Emerging market bonds correlate to the U.S. Dollar. They perform poorly when the dollar appreciates. This position has also been negative for the year. However, losses have been minimal compared to long duration emerging market bond funds. As long as the dollar remains strong and continues to appreciate, this position will remain unchanged. Should the dollar start to fall, there is an opportunity to increase the duration and potentially increase returns.
The goal in 2015 was to avoid the worst performing sectors and align the portfolios with sectors expected to perform well. The equity allocation of the portfolios is invested in the Technology, Consumer Discretionary, and Health Care sectors. These were among the top performing sectors of 2015. They are also sectors that tend to perform well as the dollar appreciates.
The worst performing sectors of 2015 were Energy, Precious Metals, Materials, Industrials and Utilities. We successfully avoided those sectors, except Industrials, which we got out of mid-year.
As long as the dollar continues to appreciate, allocations to these sectors will remain. If the dollar falls at some point, as it historically does during an interest rate hike cycle, there will be a massive shift in the allocation of the portfolios to sectors that perform well during a falling dollar.
The end-of-year rebalance was postponed du e to returns being mostly flat since the mid-year rebalance in 2015. All portfolios will be rebalanced no later than mid-2016.
While the Technology sector historically does poorly during the initial phase of an interest rate hike, it performs very well during a rising dollar cycle. As long as the dollar continues to rally, this sector is expected to continue to outperform and will remain part of the portfolios.
Consumer Discretionary (Retail)
Recent expectations were that the Retail sector would outperform. Consumers have more discretionary income due to lower fuel prices and warmer temperatures. However, despite the increased discretionary income, and Retail being a dollar bullish sector, it has failed to meet expectations. This position will be closely monitored. Adjustments will be made should it continue to underperform.
Health Care (Biotechnology)
While the Health Care sector generally performs poorly in an early rate hike cycle, it has a strong correlation to the U.S. dollar. The Biotechnology subsector outperformed the market this year. It usually outperforms the broad Health Care sector. As long as the U.S. dollar continues to appreciate, expectations are this sector will to continue to outperform.
I recently read an interesting article by an expert who suggested the Utilities sector would be the best performing sector in 2016. At first pass, this was easy to disregard since Utility stocks perform poorly in a rising interest rate environment. The reason they underperform is that investors typically buy Utility stocks for the dividend. As interest rates rise, dividend focused investors tend to switch to buying bonds since bonds can offer the same yield without market volatility.
The expert suggested Utilities may outperform because this sector correlates with long-term rather than short-term interest rates. With long-term rates approaching a technical peak, there is an opportunity to add this sector to the portfolios when the long-term rates peak.
The Banking sector performs well when interest rates rise. Until recently, it was a top candidate for the portfolios going into 2016. Upon deeper analysis, this sector correlates with long-term interest rates, instead of short-term interest rates. Anticipating that long-term rates could fall, this sector will be held out of the portfolios until further notice.
Energy, Precious Metals, Materials & Industrials
I expect these sectors to generate quite a bit of interest in 2016 because their valuations are very low. Following the rule of “buy low and sell high,” these sectors can be attractive due to their low valuations. It is important to understand the reason these sectors are low is that they perform poorly during a rising dollar cycle. As long as the U.S. dollar continues to rally, it is likely these sectors will remain low with limited upside potential. Until the dollar shifts to a sustained downward trend, these sectors will remain out of the portfolios.
The Real Estate sector performs well when long-term interest rates drop. Knowing that long-term rates could drop, this sector will also be a candidate for the portfolios.
Foreign stocks perform well when other nations devalue their currencies. Since many other countries are engaging in economic policies to devalue their currencies, such as Quantitative Easing and bond purchase programs, foreign stocks are expected to outperform. It is worth noting that the portfolios have very small exposure to China.
The Emerging Markets sector performs well during a weakening dollar. As long as the dollar continues to appreciate, this sector will likely continue to underperform.
Many experts present a negative outlook for the markets in 2016. However, I remain cautiously optimistic that we will successfully navigate through challenges of a strong dollar coupled with rising interest rates.
I did a great deal of research in 2015 to further build upon the successes we have achieved thus far. That research, coupled with my routine monitoring of the markets and the economy, should put us in a position to outperform once again in 2016.
As always, I appreciate the opportunity to serve you as my client and the trust you place in me to manage your money. Thank you for all of the referrals!