Greater clarity on Fed policy, but not on financial market outcomes

08/05/2019

John Fujiwara explains why the Fed’s policy pivot may infer more – not less – financial market uncertainty and why diversification matters in this environment.

Key takeaways

  • The Fed’s pivot to a more accommodative policy bias begs the question, “Why did they do it?” One possibility is a weakening economy, another is the goal of lifting inflation.
  • In either scenario, some of the asset classes that have rallied in 2019 may be at risk of losing value.
  • Given this uncertainty, we believe that investors should place a strong emphasis on portfolio diversification, with the aim of dampening any drawdowns that may occur in their stock and bond holdings.

A central component of US monetary policy over the past decade has been forward guidance, that is, transparency on future policy moves. As recently as last summer, Federal Reserve (Fed) officials maintained the drumbeat of additional rate hikes, speaking often of an elusive neutral rate. Also laid out was their planned balance sheet roll-off of Treasuries. Officials’ rhetoric shifted in December as they announced the central bank would effectively pause its normalisation program. The market already had anticipated the Fed would likely have to take a more dovish path than what earlier dot-plot surveys had inferred, but the central bank’s tacit admission that either the economy or markets – or both – could not handle materially higher interest rates seemingly confirmed that the so-called Fed “put” remained intact. A more dovish stance was reaffirmed with March’s announcement of a sooner-than-expected cessation of Treasuries rolling off the Fed’s balance sheet.

Rather than taking a zero-sum approach as to which asset class should be a candidate for underweighting, we believe that portfolios become more diversified by acts of inclusion, not exclusion.”

John Fujiwara, Portfolio Manager, Diversified Alternatives

A glass half full – or half empty?

With both of these initiatives likely having been tabled, the question is, why? One possibility is the Fed sees a disturbing trend in economic data that it believes merits greater accommodation. Alternatively, in its long quest to ignite inflation, the central bank is willing to keep the money supply expansive despite a healthy economy. Implicit in that scenario is them willing to allow inflation to run above its targeted level of 2.0%. This policy shift had the effect of spurring 2019’s rally in both safe-haven Treasuries and riskier assets.

We cannot predict which scenario will ultimately transpire. Each, however, could have its own implications for financial markets. Should the Fed allow inflation to exceed 2.0%, investors may have to prepare for higher long-term interest rates. In such a “bear-steepening” environment, assets typically correlated with inflation would be expected to do well, as would some stocks – as long as prices do not accelerate too rapidly. Bonds in this environment would be expected to do poorly. If, however, economic growth dramatically slows, despite the Fed’s best efforts, pro-cyclical asset classes such as stocks, corporate bonds and certain commodities would likely suffer and Treasuries – even with suppressed yields – may be the destination of choice for investors.

Stocks? Bonds? Other? All of the above

This potential for such binary outcomes is an argument for investors to pay extra attention to portfolio diversification. Although government bonds, corporate credits and equities have all rallied year to date, we would not be surprised to see at least one of these categories experience pressure as economic conditions evolve. Rather than taking a zero-sum approach as to which asset class should be a candidate for underweighting, we believe that portfolios become more diversified by acts of inclusion, not exclusion. The key is to identify strategies complementary to existing portfolio components, especially with regard to lowering volatility and generating uncorrelated returns.

With the proliferation of strategies designed to achieve these objectives, investors can now more easily diversify their holdings with the aim of downside protection while also maintaining exposure to their core equity and bond allocations.

Prudence preferred

With unemployment low, inflation apparently tame and risk assets on an upward trajectory, many investors may be tempted to overweight their allocation toward equities, while also knowing the Fed “has their back” with regard to Treasuries. We would argue that a more prudent approach is introducing diversification to one’s portfolio a touch too early rather than a touch too late. We still believe that the era of easy money will probably spawn unintended consequences. Some could present challenges for riskier assets, others for bonds.

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