Where does your portfolio rate?

Wealth management pros offer varying advice for investing in a high interest rate environment.

From the pages of In Business magazine.

With the U.S. economy expanding at what it considers to be a healthy pace — not too hot, not too cold — the Federal Reserve finally has embarked on a path to higher interest rates. In December, the Fed raised the Fed Funds Rate, its benchmark interest rate, for the first time in a year and only the second time since the beginning of the 2008–09 financial crisis.

The question on every aging investor’s mind is: As I approach retirement, how should a rising rate environment impact my personal investment strategy? The answers vary, according to a group of experts in banking and wealth management.

Citing steady growth in gross domestic product, continuing improvement in the labor market, and a slight uptick in inflation, the Fed also signaled it would prevent the economy from growing too quickly by raising rates more often this year. How frequently those rate increases come and to what degree they are raised is anyone’s guess, but there is little doubt we’ve finally entered a higher interest rate environment.

“Dramatically increasing interest rates have not happened since the early 1980s,” notes Nathan Brinkman, president of Triumph Wealth Management in Madison. “So the way in which you approach this is not something people have given a lot of thought to recently.”

Based on inquiries from clients, local financial experts are devoting thought to it, and they provided some investment guidance.

Rate rise rationale

While President Trump wants to boost annual economic growth to 4%, the economy’s current average of 2% growth, combined with an unemployment rate that has fallen to 4.7%, led the Federal Reserve to conclude the economy is growing at a healthy pace and will continue to perform well.

UBS Financial Services is projecting two interest rate increases in 2017. UBS expects an increase in the second quarter from 63 to 88 basis points and in the fourth quarter to 113 basis points. Andrew Burish, managing director for the Burish Group at UBS Financial Services, says the Federal Reserve was behind the curve and should have started raising rates two years ago.

“They forecast in October of 2014 that they were going to raise rates in 2015 and 2016, and they only did one in 2015 and one in 2016, so they are just way behind,” Burish states. “They thought the economy would accelerate above 1.5% or 2% and it didn’t. They thought that monetary stimulus was the way to bring about that acceleration, so now what’s going to happen, what the market is telling us today, is there’s going to be an acceleration of economic growth in the United States because of a pro-business president.”

Burish says the baton is being passed from monetary stimulus to fiscal stimulus that will include comprehensive tax reform — a significant reduction in corporate and individual taxes — deregulation, and infrastructure investment, and that’s why investors expect more inflation. “We’re going to have acceleration in the economy from a pro-business president regardless of his protectionist views on trade,” Burish states.

Even with the divisive environment in Washington, Burish says there is a good chance that all three types of fiscal stimulus will be enacted this year.

Others note investor confidence has been on an upward trajectory for several months. Brinkman says investor confidence went up substantially after Great Britain voted to exit the European Union. Since the British exit, or Brexit vote, the strong market performance is largely due to a substantial rise in short-term interest rates. “They had bottomed out on July 8 and went up substantially throughout the rest of the year,” Brinkman says. “Those are the short-term bonds and debt instruments that did extraordinarily well with extraordinarily great returns.”

Brinkman foresees at least two interest rate increases, the first in late spring or early summer, and ruled out back-to-back raises unless the economy heats up. With the Fed’s belief that the economy is growing at the maximum sustainable pace, and the new president wanting to exceed that pace, some observers believe the Fed would raise rates more quickly to keep a faster-growing economy from overheating and therefore prevent a spike in inflation. “Some of the pricing of the market was already done post-election, so if Trump goes with regulatory relaxation and tax breaks, you

could see corporations and businesses get really excited about that and they may go back to investing more heavily in their businesses,” Brinkman explains.

Mark Drachenberg, vice president and senior portfolio manager for State Bank of Cross Plains, says while the Fed has not mentioned the potential for fiscal stimulus in its interest rate guidance, the Trump tripod of stimulus, if enacted in total, would be an inducement to further raising rates. “In their eyes, it was too soon to take into account what might be coming from the new administration,” Drachenberg explains. “It depends on the actual signs they see in the economic data, but those are pro-growth policies and if they kick in to the level that would cause the other underlying economic data to increase, then yes, the Fed could conceivably raise rates beyond what they have indicated.”

Dan Savage, senior vice president and senior trust officer for State Bank of Cross Plains, cites one unknown in that scenario, and it doesn’t come from Democrats. Even though Trump is a Republican and Republicans also control the House of Representatives and the U.S. Senate, Savage notes that Republican spending hawks could balk at massive infrastructure spending.

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Strategic sensibilities

What investment strategies might make the best of this situation? For those approaching retirement, interest rates could rise fast enough to take a less aggressive approach with equities and place more money in fixed-income instruments. Brinkman says this might appeal to baby boomers with a high concentration of wealth in their account balances. “The way this movie is playing out is pretty interesting for them,” he notes. “As they look for income, and they’re looking to shift down in risk, this falls directly in line with rising interest rates.”

Brinkman called this the interplay between risk and return at the intersection of volatility. “How much risk am I able to stomach to watch my accounts go up and down? How often do I want that to happen? And then the other caveat goes into, ‘If I stop working and I retire, I’m going to be dependent on my investments to give me some type of an income.’”

Not everyone is onboard with downsizing risk, arguing that the decision to take a conservative investment approach is situational, even for some approaching retirement. There is a school of thought that as you approach retirement age, you should be more conservative to solidify your gains — meaning more bond exposure and less stock exposure — but Savage says that’s not always the case due to greatly expanded life expectancy and other factors. “A lot depends on the individuals who have considerable wealth and/or large pensions and Social Security incomes,” he states. “You could make a case for them to be more growth-oriented and less defensive, so some of that depends on individual circumstances. We hate to paint things with the broad brush.”

In addition to its forecast for gradual interest rate increases, UBS believes that equities around the world will be better investments than fixed-income, that there will be no recession in sight in 2017 or 2018, and that these conditions will be a tailwind for international stocks and a headwind for U.S. stocks. Burish says U.S. stocks will still go up, but with a weaker Euro and a stronger dollar, foreign stocks will play catch up after lagging U.S. stocks for several years.

With global growth underway, UBS believes investors should have 25% to 35% of their equity money in international equities, whether they are buying an index fund or dividend paying equity money. Burish notes that 45% of the European economy is export-oriented and 25% of that goes to emerging markets — namely, China and India.

According to Burish, rising rates also are a tailwind for bank equities because they will have increased fixed income and currency-trading revenue, and there will be more operating leverage inherent in financial companies with a strong economy and rising rates. The best performers in this scenario are likely to be financial service companies, whether it’s banks, brokers, or insurance companies. “If rates are going up because the economy is strong, financial companies will have the most operating revenue, and by the way they are going to be deregulated,” he adds, referring to talk of modifying the Dodd-Frank law. “They have been reregulated the past decade and now they are going to loosen up some of the regulations, so they’ve got some tailwind.”

From the standpoint of the interest rate environment, Savage says the issue is not domestic stocks versus international stocks, but which economic sectors are more impacted by a rising rate environment. For example, utility stocks and consumer discretionary stocks tend to not do as well in a rising rate environment, whereas the energy, technology, and health care sectors tend to do better.

Would Savage recommend changing an investment strategy simply because of the rising rate environment? “I don’t know that we would necessarily change the strategies for how a portfolio might be managed, other than you might be mindful of those certain areas,” he states. “You might not lean as heavily into utility stocks as you might have under normal circumstances, but I wouldn’t necessarily avoid them either.”

Investors have emphasized higher dividend yielding stocks, but as interest rates tick up they tend to shift back into the perceived safety net of the bonds, Savage explains. As they do that, they sell out of the utility stocks and then there is selling pressure on those, which radically drives down their price. “In other words, as the interest rate environment begins to approach or go beyond those dividend yields, those dividend-paying stocks become a little less attractive because they’re subject to downside price movement, whereas that might not be the case with a bond,” Savage explains.

Savage counsels that a diversified portfolio is well aligned with a period of gradual rate increases. “As you make shortened durations on your fixed-income portfolio, you may consider the usage of high-yield funds, and then the laddering out of the individual bonds,” he advises. “These aren’t dramatic changes. They are more tweaks to be mindful of the exposure that portfolios would have, but we are not making wholesale adjustments that are akin to timing markets.”

Drachenberg cautioned against giving in to the temptation to chase yields. “We would encourage people not to take that bait and go out and buy 10- or 15-year bonds because rates should gradually work themselves back up the ladder, or stagger their maturities and keep them toward the two and three-year level on the far end and points in between,” he says. “They should be able to capitalize on a gradually rising interest rate environment.”

If the Dodd-Frank financial reform law is altered in ways that reduce compliance costs and improve bank balance sheets, investors might look to financial stocks. Deregulation would also help bank depositors who have been starved for yield. “A lot of people are getting well under 1% yields,” Savage notes. “As the Fed begins to increase that federal funds rate, and other rates tag along with it, hopefully from an investor standpoint we and the other banks will steadily but consistently raise the rate on what we’re paying for deposit products.”

Crediting your account

As the economy improves, Brinkman believes credit quality should improve, especially in the corporate bond market and the bank loan debt market, because investments will have less volatility and more confidence in the underlying risk in debt instruments such as bonds. “A rising tide raises all boats,” Brinkman states. “Even with what one would call lower credit-quality investments, when the economy improves, that quality improves as well. Just being sensitive to credit quality, being sensitive to interest rates, is going to take effort, but it could be a winning combination for those who are paying attention.”

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Trump’s discount double check

One of President Trump’s first executive orders was to suspend indefinitely a cut on fees charged in a federal mortgage program designed to help low-income and first-time homebuyers.

The discount, announced in December by former Housing and Urban Development Secretary Julian Castro, would have cut fees by a quarter of a percentage point on mortgage insurance offered by the Federal Housing Administration. The FHA, which backs about 1 in 5 home mortgages nationally, helps homebuyers with less-than-ideal credit scores or who are only able to make a small down payment. It was created in 1934 to help stimulate the housing industry during the Great Depression.

The discount, a response to the rising interest rate environment, was to take effect on Jan. 27, saving about $500 annually on insurance premiums for homebuyers who borrowed $200,000. Ben Carson, Trump’s nominee to lead Housing and Urban Development, promised to examine the cut, but leading Democrats immediately denounced the move as a betrayal to Trump’s pledge to help working-class Americans.

The reason for the review is to assess risk to the FHA’s mortgage insurance fund, which allocates money to provide some protection for bank losses when high-risk borrowers default on their mortgages. Critics contend the agency has a history of not charging high enough fees to cover its losses, and in 2013 the agency needed an infusion of $2 billion in taxpayer money. By law, the FHA must maintain a minimum capital ratio of 2%, and its capital ratio now stands at 2.32%.

Part of the Obama administration’s rationale for the discount was that the FHA’s balance sheet is healthier now, according to Rose Oswald Poels, president/CEO of the Wisconsin Bankers Association. “The amount of money in FHA’s mortgage insurance fund had gotten above the statutory minimum level, and that was their rationale for offering the discount in the first place,” she notes. “I don’t know enough to say whether the Trump administration believes the statutory minimum level is too low.”

If made permanent, the suspension of the discount would impact another set of pocketbooks. Noting that it was a reduction of a quarter percent, and right now the maximum FHA loan amount in Dane County is $286,350, Capitol Bank’s Ken Thompson notes that one quarter percent of that is $708.86 or roughly $59 a month, “so it’s material in and of itself, without a doubt.”

If he were a betting man, Thompson, president/CEO of Capitol Bank, would wager the discount would either be reinstated or modified, but not eliminated. “I would tend to think it would be a quarter to something less,” he states.

An even larger risk to homeowners could be rising interest rates and perhaps federal tax reform that eliminates standard deductions in exchange for lower tax rates. The Federal Reserve has signaled it will be more aggressive in raising interest rates in 2017, and that’s without the possibility of a boost in economic growth beyond the current 2%, but there is less likelihood that the mortgage interest deduction, which is popular with the public, would be a casualty of tax simplification.

“I think the greatest risk to homeowners is rising interest rates because they could go up easily, more than the quarter percent that we are talking about with mortgage insurance,” Thompson notes. “And then the other topic up for debate is the home mortgage interest deduction and that again would have a negative impact for homebuyers because right now you get to deduct that interest.

“That [tax reform] effort bears watching.”

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