Are your clients ready for the QE aftermath?News added by Benefits Pro on April 11, 2014

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By Paula Aven Gladych

The government can’t continue buying bonds forever in an attempt to keep the economy rolling. Eventually, the gravy train will end and interest rates will rebound from the depressed levels they have been at for the past five years. Before quantitative easing ends, investors need to anticipate what soaring interest rates will do to their portfolios — especially if they are close to retirement and have a good chunk of their savings in bonds.

Most advisors agree that the typical asset allocation of 60 percent equities and 40 percent bonds won’t work in a rising interest rate environment. They do, however, disagree on how retirement portfolios should be changed to hedge against the coming storm.

“We somehow as humans have something programmed into our DNA that the farther we move from a bad experience, we convince ourselves it is impossible to happen again,” said Steve Blumenthal, founder and CEO of CMG Capital Management Group Inc. in King of Prussia, Penn. “That is good for participating in life but bad for investors.”

Blumenthal is concerned that investors have become complacent again, given that we are five years out from the stock market drop that caused the economy to plunge into the Big Recession. A rising stock market over the past couple of years has encouraged many investors to jump back into the market with both feet.

The economy has improved with the help of the Federal Reserve’s bond repurchasing program, to the tune of $85 billion a month at the end of 2013. That amount is slowly tapering off now, with the Fed lowering its monthly buyback amount to $55 billion at the beginning of April. The agency has not raised interest rates yet.

Federal Reserve Chair Janet Yellen said in March that the Fed’s bond buyback program could end as early as this fall. When asked how soon after interest rates would rise, she said within six months after quantitative easing ends.

The Federal Open Market Committee, which Yellen heads up, said in December 2012 it wouldn’t consider raising the short-term interest rate until unemployment fell to 6.5 percent. At the time, unemployment was at 7.8 percent. Now, with unemployment down to 6.7 percent, Yellen was asked again if rates would rise at the 6.5 percent threshold. She responded that it wouldn’t happen because the committee takes into account numerous factors besides the unemployment rate, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.
Most financial advisors see the writing on the wall and expect interest rates to begin creeping back up to normal levels by the middle of 2015, so it is imperative that investors evaluate their portfolios and make sure they have “some form of portfolio protection in place,” said Blumenthal.

That comes in the form of long-term equity portfolio exposure, or those stocks you want to hold for the long run, he said.

“I do not believe it is necessary to hedge your tactical or alternative allocations as they should have risk management processes built in,” Blumenthal said.

He pointed out that neither the stock nor bond markets do well in an up interest rate environment.

Blumenthal keeps tabs on the Federal Open Market Committee. The 13 Fed FOMC participants are polled frequently about where they believe interest rates will be in the coming months. The most recent poll showed one member believing that rates could go from 0 percent to 1 percent sometime in 2014. The majority of members believe it will jump to 1 percent in 2015 and one said they thought it would reach 3 percent.

“The Fed exit is no small thing. I think the markets are ill-prepared for how painful it will be,” Blumenthal said. In 2016, most of the committee members believe rates will be above 2 percent, he added. “I don’t think that is on anyone’s radar screen. After that, it goes to 3 to 4 percent or normal range. Unwinding will be a big problem to the system. Forget cutting back on purchases. The uptick on interest rates alone will be difficult. Bonds will be hurt and stocks will be hurt.”

Blumenthal recommends reducing equity exposure. “Valuations are really high today and the risk is even higher. Margin debt is at record levels and the amount of cash mutual funds have is 3 percent, some of the lowest levels in history. There is not a lot of firepower there,” he said.

He believes investors should switch from 60 percent equities/40 percent bonds to 30 percent equities, smartly hedged, 30 percent fixed income, like flexible bond funds that have the ability to shorten or lengthen maturity to be more tactical with their decisions, and 40 percent to tactical strategies that offer broad asset allocation flexibility — relative strength, trend following, sector rotation and risk managed strategies.

This way, when there is a “major correction, you are in a healthy position to buy great stocks at low prices when the risk is not like it is today,” Blumenthal said. “They you can shift back to 60/40. Right now, for this environment, people have been sucked out of stocks into bond portfolios. The risk is very big.”

Matt Curfman, co-owner and senior vice president of Richmond Brothers Inc., a registered investment advisory firm in Jackson, Mich., works with individual investors, the large majority of whom are baby boomers.

He tries to keep the information he gives to clients simple and eliminate the jargon. When speaking about quantitative easing he tries to be positive.
“I try to tell clients that [the government is] backing off how much they are supporting the economy. Why that is positive, in theory, is that consumer spending is increasing enough and the economic indicators are improving enough that the economy can stand on its own two feet,” Curfman said. “Nobody thought the government would continue to pump money into the economy with no end in sight.”

Tapering has started and so far the Fed has reduced what it is pumping into the economy by $10 billion a month.

He added that people would be shocked if the Fed backed off faster than that or stopped tapering altogether.

Most individual investors have no idea what QE stands for, but Richmond Brothers took Yellen’s comments in May of last year as a “warning shot” to change how people allocate investments in their retirement portfolios. The bond market collapsed for the rest of the year when the Fed casually mentioned it would eventually raise the short-term interest rate it controls.

“Historically, retirees would have a larger exposure to bonds, but we’re at the wrong end of the interest rate cycle to be heavy in bonds in my opinion,” he said. Investors can own low-duration or short bonds, he said, but can’t expect much return on them.

The company began shifting its clients away from bonds last year.

“I don’t think we have a single client that has more than a 10 percent bond exposure,” Curfman said.

This year, the bond index is actually up when the market is relatively flat, he added. “So for the first three months of the year, our theory isn’t proving out.”

He predicts that if the Fed rate stays low, investors will look for less risky opportunities to bonds. He believes “a lot of money will flow into the stock market, with a heavier focus on dividend-producing equities.”

Because most of his company’s investors are already retired, they need investments that will continue to produce a good cash flow.

“Everyone has got their own take. You do the best you can with the information you have now. As the environment changes, you better be willing to change your plan,” Curfman said.

Investors can’t just stick their heads in the sand and hope the problems blow over, he added. That may have worked for the past 30 years, but “I don’t think that will be the case now.”

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