After The Fed's Surprise: 4 Asset Allocation Implications

by: Russ Koesterich, CFA

The Federal Reserve's no-taper announcement was certainly a surprise. I had expected a "taper lite" rather than a hold. Still, the announcement is consistent with my expectation that the U.S. recovery will remain slow and that interest rates are likely to finish the year around where they are now. By failing to taper, the Fed signaled to the market that there are still lingering questions regarding the strength of the U.S. recovery. Of particular concern is the resilience of the housing recovery in the face of rising interest rates.

What does this mean for investors? As I write in my latest weekly commentary, the Fed's decision confirms some of my asset allocation views and tempers others. In particular, there are four asset allocation implications of the Fed news:

1. Rate-sensitive assets may get a temporary reprieve after the Fed news, but I remain underweight two such asset classes: global utility stocks and gold. While I recognize that softness in these assets may be delayed because real interest rates will not rise as quickly as investors had feared, I still expect real rates to rise over the longer term.

2. I remain overweight equities vs. bonds. A slower taper suggests easier monetary policy for longer, a development, which is consistent with our overweight view of global equities.

3. Within equities, more aggressive investors should consider overweighting emerging markets. A more accommodative monetary policy is supportive of emerging markets.

4. Within fixed income, I continue to favor credit sectors over Treasuries. An environment in which rates are contained but economic growth continues is likely to be supportive of high-yield bonds.

Beyond specific asset allocation implications, the Fed's decision was also a tacit acknowledgement that Washington can still cause market mischief. As I wrote earlier this month, I expect that market attention is soon going to switch to the Congressional budget battle, meaning there's likely more market volatility ahead. In his comments, the Fed chief himself cited the potential for volatility around the upcoming budget battle.

Source: Bloomberg.

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