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A rate hike will change your portfolio more than you think

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People can’t be sure that any of their investments will be profitable. That’s why they are advised to have diversified portfolios: hopefully, they can compensate for losses on some investments with gains on others. If all their eggs are in one basket they can’t offset a loss when that bet goes wrong.

To put together a diversified portfolio, investors need to find assets that don’t move together – some that go up when others go down. But what if they can’t find any?

This is not idle speculation. Building well-diversified portfolios has become difficult. Not only risk assets have been moving increasingly in sync with each other, but also the main source of diversification that investors have counted on for more than three decades – bonds – could be lost soon. This will leave them with fewer options to protect themselves against a market turn.

Markets are jittery because the U.S. Federal Reserve is once again signaling that it wants to raise rates soon. This is due to improving labor conditions, as manifested by a huge jobs report last week that far exceeded expectations, and by the relentless drop in the number of people initially applying for unemployment benefits, which is now at its lowest point since 1968. In addition, average hourly earnings went up by the largest yearly increase since 2009. The strong labor market is giving the Fed the excuse it needs to raise rates.

It is not yet clear that this is the right move. Weak global economic conditions have worsened since the Fed itself cited them as a reason to hold off on a rate hike. Also, inflation at the consumer and producer level continues to be very low and is still falling. But the Fed is itching to normalize monetary policy (i.e. raise rates), and when they finally do, they will likely put an end to a 33-year-long rally in bonds.  

During more than three decades investors have offset part of the stock market risk by allocating a portion of their portfolios to bonds. This has been a successful strategy because, as rates fell from double-digit levels in the early 1980s to low single digits today, bond portfolios could be counted on to deliver positive returns. Not everyone stopped to reflect on the fact that a multi-decade decline in interest rates had a lot to do with the ability of bonds to provide this kind of cozy refuge. Many erroneously assume that bonds are safe by nature. This is not so.

The Fed’s push to raise rates could impact the status of bonds as a safe haven. The only way for bonds not to be affected by an interest rate hike would be if the Fed turns out to be wrong in raising rates, as Japan found out in 2002 (see our previous newsletter). If so, the rate hike could cause a substantial fall in economic activity, requiring the Fed to backtrack and cut rates again. The worst-case scenario would be if the rate hike triggers a bout of deflation. These are not trivial risks.

Barring this dismal scenario, rates are bound to rise when the Fed starts tightening monetary policy, causing bond prices to fall and inflicting losses on bondholders. The periodic coupons that bonds pay today are still too small to provide any significant relief against such losses.

Where else can market participants find diversification? Cash is an obvious choice. Another is within equity markets. Traditionally, this has been achieved by identifying “aggressive” sectors (such as technology, or consumer discretionary) and “defensive” sectors (like utilities or consumer staples) that, in theory at least, would move in different directions during different stages of the market cycle.

But the ability to diversify risk away through sector rotation largely evaporated from equity markets after the financial crisis. Investors, whether they realized it or not, had all their eggs in one basket: sectors were not moving independently enough to diversify away risk. A simple measure of diversification shows why this is so and how their equity portfolios were unprotected against a market downturn.

Diversification is based on the concept that, because some assets go up when others go down, their individual moves cancel out to some extent when they are bunched together. Therefore, a portfolio should be less volatile than its individual components.

A measure of portfolio diversification is, therefore, the difference between the average volatility of the individual components and the volatility of the whole portfolio. The more diversified the portfolio, the larger the difference. This difference is zero for a portfolio of perfectly correlated assets (one that has no diversification at all).

US Financial Sector Debt vs. Federal Debt.

After the financial crisis, this measure declined to one of its lowest levels in decades, as US equity sectors moved increasingly in unison. This rendered portfolios unable to limit market losses and turned them dependent on luck – i.e. a bull market – to do well. And luckily, the soundness of investors’ portfolios remained untested for years.

Going forward, however, market participants won’t be able to rely on bonds for protection. They will have to look at cash for safe havens, and search hard for diversification among sectors. Fortunately, sector differentiation has improved in the last few months, as the graph above shows.

This is, in part, for the wrong reasons: both the materials and energy sectors fell hard, so the big spike in diversification reflects in part the fact that those two sectors lost big compared to the rest of the market. But even taking out those two, the remaining sectors have in fact shown growing differentiation in recent months. If so, investors may find that even with bonds out of the equation, sector rotation may provide some of the protection they sorely need.

In the few years after the financial crisis investors have been lucky to coast along without having their portfolios tested in any meaningful way. If their luck runs out, and bonds are no longer there for protection, they will need to dust off their portfolio management skills quickly.

What now?

Our clients want to make sure that their investments are managed efficiently and prudently, and that they partner with an advisor who helps them cut through the market noise. We look at their specific situations and use quantitative techniques and solid execution expertise to build and maintain investment portfolios that are suitable for their needs. We try to identify when to buy or sell different asset classes, with a focus on controlling downside, seeing through the haze of short-term volatility, and looking at what securities are priced favorably at various times. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more