Welcome, Taper

Dianne Lob

The Federal Open Market Committee’s statement that it will begin to taper its bond purchases in January is a good sign that the US economy continues to heal, in our view.

The tapering does not mean an end to the Fed’s accommodative monetary policies anytime soon. It means continuing to buy bonds at a lower monthly rate (US$75 billion, not US$85 billion). The Fed explicitly said that it now expects to maintain the current target range for the fed funds rate well past the time that unemployment rates decline below 6.5%.

Volatility may rise in the short term, but in our view the US economy and markets are better positioned to absorb slightly reduced bond purchases than they were in May when the Fed first mentioned the possibility of tapering. Indeed, the market reaction to the announcement was favorable—and far different from the upset caused when the Fed first discussed the possibility in May.,

After all, US economic growth picked up in the second half of 2013, Congress is close to a budget agreement, consumer and business confidence is rising, and unemployment has declined from 7.6% in May to 7.0% in November.

Longer-term bond yields have risen about 1.0% since the possibility of tapering was first mentioned in May, but US equity markets are at all-time highs and currency markets are stable. We think that rates are likely to stay range bound until the Fed raises short-term interest rates (currently at all-time lows), which is unlikely to happen until sometime in 2015.

What Tapering Means for Bonds

High-grade bond returns have been generally negative so far in 2013 on concerns about the looming taper and rising interest rates. The rise in bond yields means the market is already pricing in future moves by the Fed. We don’t expect negative returns to last, but we also don’t expect future bond returns to approach the outsized performance of the past, when falling rates provided a sizable tailwind.

Taking into account the Fed’s latest information on the potential path of interest rates, we expect modestly positive returns, primarily in intermediate-term bonds, which are less rate sensitive than longer-term bonds. We think that emphasizing intermediate bonds and judicious credit selection will be critical in the period ahead.

We believe that moving from bonds to cash would pose a substantial income penalty to investors, since the FOMC doesn’t plan to raise short-term rates anytime soon.

What Tapering Means for Stocks

There may be more volatility in equity markets as rates rise over time, but we don’t think that the increases will derail the equity recovery, given solid underlying company fundamentals and the improving economy. Historically, equities have done well in most periods of rising rates. Those rising-rate periods when stocks didn’t fare well were typically accompanied by high levels of inflation. Today, inflation is low.

We believe that the current market environment is fostering a healthy shift from higher-dividend-yielding stocks. Since talk of potential tapering began earlier this year, higher-yielding, “defensive” sectors of the market have underperformed. We expect them to continue to lag the broader market.

What Tapering Means for Asset Allocation

In this setting, we think that a modest tactical tilt to return-seeking assets, focused on globally diversified stocks, is warranted. Low levels of equity-market volatility, low interest rates, and global stock valuations that are in line with long-term averages all support this positioning. However, stock and interest-rate hedges on a small part of the portfolio can provide protection against sharp, adverse moves in stock and bond markets.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Dianne F. Lob is Chairman of the Private Client Investment Policy Group at Bernstein Global Wealth Management, a unit of AllianceBernstein.

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