Senior Director of Investments and Fiduciary Services Miles Powell, and Regional Chief Investment Officer John Lynch discuss how interest rates may affect financial markets and investment portfolios and what actions investors should consider.
Miles Powell, Senior Director of Investments/Fiduciary Services
John Lynch, Regional Chief Investment Officer, Mid-Atlantic
Miles: Hi, I'm Miles Powell, Senior Director of Investments and Fiduciary Services for Wells Fargo Private Bank. The Federal Reserve raised interest rates at its December 14 meeting, making it only the second time it increased rates since it cut borrowing costs to practically zero back in 2008. And Fed officials also provided forward guidance for three changes in its policy rates in 2017.
Given this projection, how will the normalization of interest rates affect financial markets and investment portfolios? So joining me to discuss the potential impact and what actions investors should consider is John Lynch. John is Wells Fargo Private Bank Regional Chief Investment Officer for the Mid-Atlantic region. So welcome John.
John: Thanks Miles, glad to be here.
Miles: John, we're likely to see some interesting developments in 2017. We've got an incoming new U.S. president and of course there's also the impact of geopolitical events, like Brexit. And so considering these global challenges, what's the likelihood that there are going be any further increases in interest rates and that will negatively impact investment portfolios?
John: Well, Miles, we believe that the Fed has several reasons to take a "go slow" approach and I'll highlight a couple of them for you today. First, inflation is not yet a threat – all that liquidity that the central banks have created, essentially these past several years, that has to transition to income before it can manifest as an inflation problem. We see that wage is still up maybe 2.7, 2.8 percent over the past year so historically rates – inflation rates or wage rates – have to be north of 4 percent before the Fed would view that as a threat. Secondly, economic growth in this cycle remains slow and certainly below historical trends as production, employment, income, and sales have all failed to return to growth levels achieved in previous economic cycles. So for those two reasons, we think the Fed will maintain a "go slow" approach.
Miles: Makes a lot of sense, John; thanks. Given that and given also the sea change in financial and political polices that we're probably going to see in the coming year, what actions do you think investors should think about in positioning their portfolios?
John: Well certainly one of the things we see shifting as interest rates nudge higher is the recent relative outperformance of passive investment strategies relative to active management. We've seen as central banks have expanded their balance sheets, the rising tide has essentially lifted all boats, which has resulted in passive strategies outperforming active. We think that a potential increase in market volatility is likely to favor active managers because they have the ability to screen out who they believe may be winners and losers in a gradually rising interest rate environment, unlike a more passive investment approach which would include all companies. This type of investment environment also may favor alternative investment strategies, many of which have underperformed in recent years – again, as central banks were raising or expanding their balance sheets.
Miles: That's very helpful. And you know one of the things I always think about with potential impact of rising rates is do you have any concerns about the bond market. And I think about investors must be nervous about higher inflation potential eating away at value of future fixed coupon payments but also principal erosion if bond prices fall.
John: Absolutely, we're paying very close attention to that. Certainly the bond market has been 35-year bull market. There's also a income-generation phase that I think investors need to be mindful of, you know. But we must keep in mind that yields for Treasuries currently remain very attractive relative to other sovereign bonds, and as a result, we think that a diversified portfolio may continue to benefit from rising interest rates.
Miles: So if I kind of recap, John, and sum up what you just said, I think, in an environment when interest rates are moving higher, investors should factor in associated portfolio impact but including in that inflation and market volatility. And I think I also heard you say active investment strategies could perform better than passive, but we always recommend an appropriate mix of both, right now, and a well-diversified bond portfolio may help manage both interest rate risk and inflation risk.
John: Exactly Miles, we continue to position investment portfolios in a diversified strategy. We like to employ four asset class approach including equities, fixed income, real assets, and alternative investments to help our investors achieve their goals.
Miles: Well, thanks John, that's really helpful. And for our listeners, we of course recommend speaking with your investment professional to review and discuss how your portfolio is positioned for these upcoming possible changes. So thank you again for listening.
All investing involves risk including the possible loss of principal. Diversification is an investment method used to help manage risk. It does not ensure a profit or protect against a loss.
Investments in fixed-income securities are subject to market, interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond's price.Credit risk is the risk that an issuer will default on payments of interest and/or principal. The risk is heightened in lower-rated bonds. If sold prior to maturity, fixed-income securities are subject to market risk. All fixed-income investments may be worth less than their original cost upon redemption or maturity.
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