Three Fed rate hikes this year? Here's how to prepare

Finding investment income won't be any easier in 2017 than it was in 2016, according to panelists at the Inside ETFs conference in Hollywood, Fla. Most panelists — and economists — expect the Federal Reserve to nudge rates higher three times this year, and that could make markets nervous, warned Paul Kim, managing director of ETF strategy at Principal Global Investors. “The Fed has hiked rates twice in the past 10 years,” he said. “Now they are expecting three or four hikes in one year — that's a big deal.” Many on Wall Street have staked out their positions, and two big players, hedge funds and insurance companies, are on opposite sides. “Hedge funds are as short the five-year Treasury note as they ever have been,” said James Meyers of PowerShares. “And buy-and-hold investors, such as pensions and insurers, are as long duration as they ever have been.” (More: Smart beta could give funds an entry into ETF market) When either side decides it's on the wrong side of the interest-rate bet, market moves could be sharp. Another concern: The Fed will no longer be emphasizing its mandate to encourage job growth, Mr. Kim said. “Focusing on price stability will take the forefront, and the Fed will be more hawkish if data supports it,” he said. Those are three reasons to be mindful of volatility, panelists said. “Assets are priced to perfection,” Mr. Kim said, meaning that any unexpected moves by the Fed or other market participants could mean big moves up or down. That's particularly true for Treasuries, said James Norman, president of QS investors. “You're not paid a lot of income for that risk," he said. And, noted moderator Elizabeth Kashner, director of ETF research at FactSet, Treasury Inflation-Protected Securities may not provide the inflation protection that some think. “Remember that TIPS have duration,” she said — meaning they, too, will decline in price when interest rates rise. Panelists suggested wide diversification among dividend-paying stocks, corporate bonds and international debt for income portfolios. “A balanced approach is very important, since we don't know which way things are going to go,” Mr. Norman said. A small position in long-dated Treasuries might make sense as a kind of insurance in case everyone is wrong and the economy slides back into deflation. Long-term Treasuries fare best when interest rates fall. The worst solution: Cash. “If you're charging 1% and inflation is running at 2%. It's going to be a tough conversation with your client,” Mr. Norman said.