The Federal Reserve has indicated it plans to raise interest rates for the first time in over 9 years as a preventative measure rather than in reaction to current economic conditions. This will affect emerging market debt securities denominated in US dollars the most. The document recommends reducing credit and duration risk in bond portfolios by focusing on maturities between 18-24 months and reallocating to longer-term securities at higher rates once hikes begin. It also suggests investing in consumer staples, healthcare, financials stocks and hedge funds for their ability to capture opportunities arising from rate hikes.

1. What should investors do to protect against an imminent raise
in interest rates?
Analysis by Investment Committee
Davos Financial Group of companies

2. 1. Possible reasons: A Preventive Measure
The Federal Reserve (FED), lead by Yanet Yellen, has indicated that it’s ready to start a
tightening cycle after more than 9 years without increasing rates. These comments
come even with slow economic growth, a modest decline in unemployment, and
historically low inflation. It seems that raising rates is a tactical move rather than a
reaction to the current economic environment.
Considering that the FED has ran out of options to continue stimulating the economy
and that the markets have been supported by a monetary policy that has injected
massive liquidity into the system, a move towards normalizing rates at this moment has
a preventive nature.
After expanding its balance sheet to historical levels to overcome the 2008 financial
crisis, it’s reasonable that the FED would take preventive steps towards normalization.
At the time, Mr. Bernanke talked about balancing the increasing debt with economic
growth which has certainly not come in the expected magnitude. The result has been
inflated asset valuations, mainly equities and fixed assets such as real estate, but
without the wage growth and consumer spending that had been projected. The FED is
in need to promote policies that stimulates sustainable growth, but with rates so close
to 0% there is no room for maneuver.
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3. 2. Assets affected
One of the most vulnerable assets are emerging market debt securities denominated in
US Dollars. The pressure on emerging market bonds has increased significantly due to
the low demand from developed markets and lower commodity prices, on top of a rise
in the relative price of the US Dollar.
The immediate reaction of investors has been to liquidate medium to long term
positions, waiting to re-enter at more attractive rates. There has also been an important
rotation away from sectors such as energy and metals to other alternatives seen as
less vulnerable. However, according to Andres Coles, Director of Davos Financial
Advisors, the anticipated rate hike may not excessively affect the sector across the
board, but rather create dispersion across industries, issuers and currencies in
particular. Emerging Markets, as a category, is still expected to offer much higher yields
than fixed income securities from developed markets which despite an increase in rates
will still not offer attractive returns.
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4. 3. Recommendations
In this regard, David Osio, CEO of Davos Financial Group, adds "Economic growth,
which is a fundamental aspect of any monetary expansion policy, will bring back
demand for products, materials and services that today, more than ever, come from
emerging markets. Globalization has made the world much more interconnected and
interdependent than in any economic cycle prior to the crisis of 2008. "Many issuers
have strengthened their balance sheets and cost structures, and have penetrated
markets like never before. Sovereign issuers have implemented policies of fiscal
discipline with the notable exception of countries such as Venezuela and Argentina,
explains David Osio.
Finally, Andres Coles notes that Davos Financial Group’s investment committee has
been repositioning bond portfolios to reduce credit and duration risk in order to limit the
impact ahead of the first rate hike. The goal is to have maturities between 18 and 24
months to then allocate to longer-term securities at rates 250-350 basis points above
current levels. With regards to the equity market, we see greater potential in consumer
staples, healthcare and financials, even though they have already started to move in
the second quarter. An allocation to hedge funds also offers a better risk-adjusted return
due to their ability to capture opportunities in specific corporate events and investment
themes.
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