While news surrounding geopolitical and financial issues is by no means in short supply, the most significant financial headline of the fourth quarter was the U.S. Federal Reserve (the Fed) increasing the target federal funds rate for the first time in nearly a decade. More specifically, the Fed’s policy-setting committee raised its benchmark interest rate, the interest rate at which a bank lends overnight funds maintained at the central bank to another depository institution, by a quarter of a percentage point from essentially zero. Since the Fed adjusts interest rates to moderate the growth or contraction of the U.S. economy, this move signaled its belief that we have largely recovered from financial wounds suffered during the 2007-2009 financial crisis. While signals of an improving economy are typically cheered by Wall Street, many investors continue to worry about the effects of current and future interest rate hikes.
Despite the rebound in stocks in the fourth quarter, the volatility that spanned much of 2015 contributed to the lackluster market performance we witnessed over the last year. As the Fed was signalling confidence in the U.S. economy, global investors were closely monitoring developments surrounding the slowing Chinese economy and intensifying emerging market turmoil related to decreasing commodity prices and weakening currencies.
Asset class returns for the quarter and the year were as follows:
|Barclays U.S. Govt./Credit—Int.||Fixed Income||-0.7%|| |
|S&P 500||Large U.S. Stock|| |
|Russell 2000||Small U.S. Stock|| |
|MSCI ACWI ex-USA||Foreign Stock|| |
|S&P Global REIT||Real Estate Securities|| |
The recent rate hike by the Fed will almost certainly not be the last. Understanding that rising interest rates will be part of the investment calculus for the foreseeable future, we think it worthwhile to highlight a few potential implications of this shift in U.S. monetary policy.
Given the comments above and the media attention surrounding the recent interest rate hike, it is reasonable to ask, “Why should I own bonds if we expect interest rates to continue increasing, and bond prices to naturally decline as a result?” In response, it is worth re-emphasizing that the value of a fixed income allocation within an investment portfolio remains unchanged. In well-functioning capital markets, today’s bond values reflect everything the market knows about current economic conditions, growth expectations, inflation, monetary policy, etc. Accordingly, the possibility and expectation of rising rates is already factored into bond prices.
As proven time and again, no one can accurately and consistently predict short-term market performance. Without knowing the exact timing and magnitude of interest rate changes, bonds still remain the critical “ballast” of our portfolios during times of stock market volatility. Investing in high-quality, short-to-intermediate-term bonds allows investors to mitigate interest rate risk while simultaneously providing some portfolio income.
While the actions of the Fed have significant short-term implications for both the U.S. and global economy, our focus remains on the factors that most influence long-term investment success for our clients; i.e., managing portfolio risk, minimizing portfolio costs and taxes, diversification, and disciplined rebalancing in times of market volatility.