After more than five years of aggressive intervention in financial markets, the Federal Reserve (Fed) seems on the cusp of ending the greatest experiment in monetary policy history. Through Quantitative Easing, the Fed hoped to create a wealth effect to stimulate spending and investing as the economy slowly reduced the build-up of excessive debt from the previous cycle. In doing so, it has deliberately pushed assets ahead of improving fundamentals and wagered that economic growth and profits would eventually catch up to validate today’s price levels.
The good news is that over the last six months there have been signs of an improving economy, according to several key indicators: consumer confidence; increased momentum in the manufacturing sector; and the unemployment rate trending down without wage growth or other signs of inflation picking up uncomfortably. Most importantly for US stock markets, bottom line earnings per share and top line sales per share estimates for this and next year show slow but steady growth.
The bad news is that investors cannot have it both ways forever. Such economic momentum, while a continued tailwind for earnings and profits, must also mean that the Fed no longer has reasons to keep its foot on the accelerator. Over the next six to nine months, markets will face two important tests. First, the Fed announced the end its program of buying bonds in late October, after steadily tapering purchases throughout the year. Second, the Fed will then have to contemplate when to begin tapping the brake by raising short-term rates. At the moment, most do not think this will occur before the summer of 2015. If it were to occur sooner, the most expensive asset classes could become vulnerable, unless expectations for future profits surprise to the upside.
This moment of truth for Fed policy will also challenge investor complacency in other ways. One of the most perverse effects of this low interest rate environment has been the almost blind and increasingly risky chase for yield. This has led income-seeking investors to “cross-dress” portfolios by buying stock-like assets in their bond portfolios (e.g. high yield bonds and levered bank loans) and bond-like assets in the stock portfolios (e.g. utilities, Master Limited Partnerships). A rising interest rate environment may prove quite difficult for portfolios that have been constructed with a poor discipline.
Volatility across all asset classes has also already increased, not just because of uncertainty over Fed policy. It has been further fueled by heightened geopolitical risk emanating from civil wars in the Middle East and Ukraine and unrest in Hong Kong and China. International economic data, especially in the Euro area and in Japan, also tell a different and worrying story to the recovery in the US. Policymakers there remain committed to additional accommodative monetary policy if necessary, which has continued to boost the demand for US Treasuries. This has helped contain the rise in US interest rates that a healthier domestic economy would normally have suggested. The US dollar has also started to rally against the Euro and the Yen and certain emerging markets currencies. The diverging paths of the Fed, the European Central Bank and the Bank of Japan also means that US investors are increasingly being paid to hedge their currency exposure when investing in developed markets abroad.
We have been active over the last quarter in preparing strategies for the risks and potential rewards of this new environment, both within and across our building blocks. Firstly, within Manager Skill, cheaper forms of insurance against a protracted and deep downturn have offered us a way to increase the expected protection from hedge fund strategies. Secondly, we are still comfortable with boosting yield within Safe by taking credit risk in global bonds without exposing this shock-absorbing area of strategies to undue risk of higher US interest rates or a flatter yield curve. Thirdly, within Market Risk, we continued to build on the opportunity that emerging market stocks first presented in early summer. We continue to monitor cheaper international equity markets for potential ways to rebalance further away from more expensive US exposure towards cheaper exposure priced for superior returns. The combination of an increase in the expected protection from hedge funds in a market downturn and the opportunities within global bonds and emerging market stocks enabled us to lower our overall allocation to Manager Skill across all Fully Diversified strategies. This change across building blocks positions Fully Diversified strategies to optimize expected returns given the risk budgets we set for each. In short, given today’s environment, we believe strategies continue to be protected appropriately against a correction while increasing the probability of upside capture given the more attractively priced opportunities we see within public markets.
As we look out toward the rest of the year and beyond, we are most vigilant about three factors:
1) The risk of changing Fed policy disrupting markets;
2) The increasingly divergent macroeconomic path the US economy is moving relative to Europe and Japan and the opportunity that may be creating; and
3) A potential escalation in geopolitical risk.
This moment of truth for markets and complacent investors may well deliver new risks and additional opportunities for us to capitalize on. We always strive to maintain the discipline that has served our clients well over several market cycles: protecting their capital in downturns and optimizing expected returns so that they maximize the probability of reaching their goals.
 Quantitative easing is the Fed’s policy of buying bonds to drive interest rates down to artificially low levels with the expectation of boosting bond and stock prices.
 According to Absolute Investment Advisors, today the size of the US bond and stock market stands at over 250% of GDP, having surpassed the previous peak of 240% reached in 2000, well in excess of the average of 110% of GDP since the end of the Great Depression in the early 1940s!