Waiting For Signs On The Fiscal Cliff - And From The Fed

by: Russ Koesterich, CFA

Investors are stuck between a rock and a hard place: They’re trying to plan for the end of 2012, while also looking ahead to 2013. It’s being reflected in the questions I’m getting from clients right now, who are worried both about the fiscal cliff and the outlook for interest rates in 2013

As we saw last week, the markets are focused on every utterance out of Washington on the fiscal cliff. For better or worse, this is unlikely to change until we have a deal. And in terms of getting to one, the truth is we did not see much progress last week.

Moreover, it is important to note that, while investors are focused on getting something done by year’s end, a more important deadline may be Christmas Eve. There are roughly 80 Congressman and Senators who will not be returning to Washington next year and many of them plan to leave before the holiday, suggesting that a deal has to be in place by the 24th. That means the parties are going to need to start to move if a compromise is to be reached in time.

Meanwhile, indicating that some investors are looking past December 31st, I’ve been getting a lot of questions on what to expect from the Federal Reserve in 2013. In short, clients are asking about the future direction of monetary policy and when the Fed might raise interest rates.

To answer that question, investors should focus on the labor market, since it is important to remember that the Fed has a dual mandate: keep prices stable, but also maximize employment. Given that the Fed is not particularly worried about inflation, changes in the labor market are likely to be the key driver for any change in monetary policy. As a rough rule of thumb, then, investors should assume the following:

1.) The Fed is likely to end quantitative easing before they start to raise rates.

2.) In terms of when that is likely to happen, look for unemployment to drop down closer to 7%. It will probably take a further drop to around 6.5% before the Fed is likely to start raising interest rates.

3.) Given the speed at which the unemployment rate is dropping, we’re probably looking at the back half of 2013, at the earliest, before we’re likely to see an end to the Fed’s asset purchases, and even longer before short-term rates are likely to rise.

Bottom line — unless we start to see the US economy producing at least 200-250k jobs a month, the unemployment rate is likely to fall very slowly. That means that the Fed will likely keep rates low and further expand its balance sheet for the foreseeable future.

For investors who need income in this environment, we would continue to advocate equities and credit, rather than duration. Potential iShares solutions include the iShares High Dividend Equity Fund (NYSEARCA:HDV), the iShares Emerging Markets Dividend Index Fund (NYSEARCA:DVYE), the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA:IDV), the iShares 10+ Year Credit Bond Fund (NYSEARCA:CLY), the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA:LQD) and the iShares S&P National AMT-Free Municipal Bond Fund (NYSEARCA:MUB).

Disclaimer: In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. There is no guarantee that dividend funds will pay dividends.

Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.

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