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Fears that the Federal Reserve would begin to "taper" the amount of monetary accommodation that it was providing the U.S. economy brought an unwelcome whiff of anxiety to financial markets in June. After steady flows into stocks and bonds during the first few months of 2013, mutual fund investors sold both in June. The table below provides a closer look at the activity during the month.
($ in billions)
Source: Investment Company Institute
While the dust appears to have settled as of early July, investors are still facing the same question that prompted the late unpleasantness: when will the Fed begin its tapering? At the central bank's June policy meeting, Fed chairman Ben Bernanke cited the possibility of an end to quantitative easing midway through 2014, with the possibility of an eventual increase in the fed funds rate in 2015.1
However, the Fed chief may find reality intruding on his plans.
As we have previously noted, the Fed is habitually optimistic in its economic outlook. In June, the policy-setting Federal Open Market Committee stated that "economic activity has been expanding at a moderate pace."2 The Fed cited improving labor market conditions, though the unemployment rate remains elevated, growth in household spending and business fixed investment, and a recovering housing sector.
But recent economic data may be telling a different story. Employment, which had accelerated to monthly job growth above 200,000 in November 2012 through February 2013, slowed to gains of 165,000 in April and 175,000 in May 2013.3 Comments by market observers—including two former Fed economists—suggest that several months of job growth averaging at least 200,000 would be needed for the Fed to justify tapering.4
Other factors argue against Bernanke's tapering timetable. Personal spending has slowed, consumer savings rates remain low, and personal income has slipped.5 Further, the manufacturing sector, which was weak in May but posted some improvement in June, has shed jobs over the past three months.6
Meanwhile, rising interest rates could weigh on one of the bright spots in the economy: the housing market. While data on existing home sales and home prices have continued their recent uptrend, higher rates may cause marginal homebuyers—who may have been spurred to action by current low mortgage rates—to delay making purchases. Higher mortgage rates also make refinancing unattractive, reducing the economic support that has been provided in recent months.
Further, recent losses in equity and fixed-income markets may make consumers feel poorer, reducing their confidence in the future and their willingness to spend money.
The Strategy for Higher Rates
What's an investor to do in the current climate? Fixed-income investors may want to consider instruments with shorter maturities and lower credit quality. Further, they could consider those credit securities whose yield is higher than their duration. In that regard, investors may wish to focus on high-yield debt, leveraged loans, and credit instruments with short maturities. Equities may also be attractive in this context.
What should investors avoid? They may wish to steer clear of traditional "safe haven" vehicles, including U.S. Treasuries, Treasury Inflation-Protected Securities (TIPS), and high-credit quality corporate bonds.
A Note about Risk: Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Bonds may also be subject to call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Mortgage-backed securities are subject to prepayment risk. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.