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As markets falter, stay diversified

As of 07-01-2013

It’s possible the past month was a nervous one for many long-term investors, perhaps even harking back to those dark days of 2008, when it seemed there was no place to hide. Treasuries sold off. Until the last week of June, domestic stocks and global stocks sold off. It seemed, in other words, as if everything was selling off.

It’s never fun when the party begins to end, and that’s what Fed policymakers and Chairman Ben Bernanke seem to be signaling—not taking away the punch bowl, necessarily, but spiking it a lot less. Indeed, it seems Bernanke was clear that the current thinking among policymakers is data dependent—meaning when and how much to taper will be a fluid decision and that the “last call’’ won’t come for a long time—2015 is the current consensus for the central bank to begin to actually tap on the brakes by initiating increases in the benchmark funds rate.

Still, it was the revelation that QE’s days are numbered that sent Treasury yields spiking and equity markets plunging following the policy-setting Federal Open Market Committee meeting on June 19.  But let’s put this into perspective. Why would the Fed feel compelled to start easing off the monetary accommodation now? It could be that the size of its balance sheet is getting too big, or maybe it wants to clear the stage before turning over the reins to the next potential new Fed president in 2014. Or it could be as simple as the Fed expects the economy to be strong enough not only to stand on its on, but to grow fast enough to put it on a path to reach the Fed’s two preferred thresholds—an unemployment rate of 6.5% or lower, and inflation of about 2% to 2.5%.

Sell first, ask questions later
If anything, the Fed’s faith in the economy should be good news for much of the investment world. But as almost always is the case when the Fed signals a potential change in its stance, the equity and bond markets reaction was to sell first, ask questions later. I’m betting once the markets emerge from their disappointment that the liquidity party won’t last forever, they will turn their attention to what has been left in the wake of five years of unprecedented Fed stimulus: an economy that has healed enough to grow on its own—without stimulus. History tells us such an environment tends to be good for growth and earnings, and thus for stocks.

But while stocks and commodities tend do better than fixed-income assets when a rising-rate environment is driven by healthy economic growth, there are opportunities in the bond world as well.  Bonds that are more sensitive to the economy—so-called high-yield corporate bonds that in some ways behave like equities because their value is aligned with corporate performance—tend to outperform Treasuries and mortgages when the economy is going well. International bonds, primarily those issued by emerging-market countries whose economies depend on global trade, also tend to perform better than U.S. government issues for similar reasons during periods of rising rates.

So what should an investor who needs current yield do in face of such volatility within the markets? Diversify into the more interest-rate and economically sensitive portions of the equity and bond markets. Rising rates will favor certain stock sectors versus others, and certain bond classes versus others.

Rising yields present opportunities
For 2013, higher anticipated yields driven by growth and policy expectations rather than inflation concerns should lead to higher equity valuations, strength in cyclical sectors and better corporate performance versus government bonds. Cyclical areas of the market include technology, energy and even some financial companies, all of which may benefit from rising rates more than utilities, telecom or consumer staples sectors.

Don’t just buy yield. Investors at this point in the cycle also should look for a balance of dividend yield and growth—maybe tilted more towards dividend growth. Look for companies that have more leverage to the underlying economy, meaning as economy steadily improves, these companies should exhibit relatively stronger and healthier corporate cash and profitability. In general, ex-U.S. companies tend to pay higher yields, so look for some balance of yield and dividend growth backed by improving fundamentals, cash flows and balance sheets in international companies as well. The added complexity of international investing comes from having to do more work on where you’re investing; in other words, look at countries with strong current and paticularly projected economic growth.

The bottom line: for long-term investors, diversifying across asset classes and geographic boundaries at any time, particularly during periods of rising rates, can improve the opportunities to capture yield and improve returns without unduly increasing the potential exposure to risk. This is worth remembering in this era of the 24/7 news cycle that, with its instantaneous if not often shallow and in some cases sensationalized analysis, spawns overreaction and undue consternation.

A version of this article first appeared on

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.
Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.
Diversification and asset allocation do not assure a profit nor protect against loss.
High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risk and may be more volatile than investment-grade securities. For example, their prices are more volatile, economic downturns and financial setbacks may affect their prices more negatively, and their trading market may be more limited.
International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-markets securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.
Prices of commodities may rise and fall in response to many factors such as economic, political and regulatory developments.
The dividend yield represents the average yield of the underlying securities within the portfolio.
Federated Equity Management Co. of Pennsylvania
Copyright © 2014 Federated Investors, Inc.

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