Investors are fidgety about central banks’ policies, especially the prospect of a rate rise in the US. But they should look beyond the macro ‘noise’ and take a patient approach.
A lack of confidence in central banks and public policy is one of the principal concerns among investors, according to Philip Saunders, co-head of Multi-Asset at Investec Asset Management, who was addressing the Investec Global Insights 2015 client conference.
Central bank policy has made the markets less liquid in recent years, said Saunders, leaving them reliant on high-frequency traders to provide liquidity and running the risk of poor asset allocation from investors.
“Their models are broken and they are making it up as they go along,” said Saunders. It is inevitable, therefore, that mistakes will be made by central banks, as has been seen in China recently and, some would argue, at the Federal Reserve.
When Fed head Janet Yellen, otherwise known as the Fairy Godmother of the Bull market, announced on September 17 that she was going to leave interest rates unchanged yet again, the market took a dovish view of her remarks.
It is clear that the Fed will raise rates reasonably soon. It would like to do it gradually and return the rates to a normal level (it has not raised interest rates since 2006). “It will likely be some time later this year and there will be a gradual rise thereafter,” said Yellen.
One of the reasons for the refusal to raise rates was the recent turmoil in China, however Yellen stated that any volatility from beyond the US borders was unlikely to have any long-term impact on policy. “We are monitoring developments abroad but don’t think they will be large enough to affect our plans.”
What is more likely is that the Fed’s decision will be driven by domestic data, especially the jobs market, where unemployment has risen to over 10%, and inflation, which is still not back to the 2% that the Fed is looking for. As Yellen said: “We’d like to have a little bit more confidence.”
So what might the market do? “The hiking cycle might be more gradual than it has been in the past but faster than the market expects,” said John Stopford, co-head of Multi-Asset at Investec Asset Management. After all, said Stopford, the market has been wrong about this before.
“Yes, the Fed has been slow to raise interest rates but that is because when it finally goes, it wants to be sure it can continue to raise rates gradually. This is not a ‘one-and-done’.”
Investors have historically tended to underestimate the extent of any Fed intervention, said Stopford. 2004 is the only time that, going into a hike cycle, the market has overpriced. An analysis of market behaviour (returns vs US dollar deposits) in previous hiking cycles shows that most assets did well in 2004 but poorly in other cycles, notably 1994.
Of the various instruments, equities and emerging market local currency debt tended to do well, while government and investment grade bonds and real estate investment trusts mostly did poorly. Above all though, there were inconsistent outcomes which suggested there were other factors at play besides changes in interest rates.
Stopford also showed what assets have tended to be most sensitive to rate changes. The clearest correlations were positive for equities and negative for government bonds. Higher-yielding assets tended to be either positive or show little correlation, while the US dollar showed very little correlation of any sort.
The situation today is that many bonds may not be priced correctly for rate increases. “We think the market is potentially mispriced,” said Stopford. “The Fed is girding its loins, so investors have to think about the valuations of income-generating investments.”
Even if interest rates do go up in the next month or shortly after, they are not likely to go up by much, said Stopford, and that will help high-yielding assets. Additionally, in a world where capital return is uncertain, a rise in interest rates will increase confidence in income-generated assets.
There are additional factors for investors to consider. For example, some governments are still persisting with quantitative easing as a means to keep government yields low. There are also demographic factors such as the fact that the developed world’s populations are getting older. In Japan, there will soon be an equal number of retirees and young people.
A close look at the equities market shows that equity yields have risen, but this does not mean we are about to enter a bear market, said Stopford, citing the fact that equities tend to peak just before the end of a market cycle. By contrast, credit tends to peak earlier. “We would rather manage our corporate risk through equities because they look OK, whereas credit may be peaked last year. That could be an amber light that we are perhaps one or two years away from a bear market.”
Meanwhile the emerging markets will likely be driven by changes to the US dollar and the commodities markets. But the hope is that much of the potentially bad news has already been priced into emerging market assets with further discounting for poorly performing commodities, said Stopford.
Despite the generally constructive attitude towards the performance of income assets, Stopford did remind his audience that a good portfolio has to have some exposure to growth, defensive and uncorrelated assets that can provide some diversification. Government bonds typically fit the defensive role but they tend to be expensive at the moment, said Stopford. “That is why it is important to look for value, so look at Australia, New Zealand and Japan rather than the US or the UK.”
Meanwhile, Stopford’s co-head in the Multi-Asset team urged investors not to bet against the US consumer. “We are beginning to see a return to more normal consumer behaviour after some balance sheet issues,” said Saunders. For example, vehicle sales are up in the US, which suggests consumers are spending their “gasoline dividend”.
Any US rate rises will be relatively muted and the US dollar has been stable against the euro and the yen, so the risk of any sudden moves in the dollar should not be exaggerated, said Saunders. And with the market increasingly priced for economic weakness, there are likely to be buying opportunities for those that can look beyond macro noise and take a bottom-up approach to asset allocation.
Investec’s Multi-Asset team tries to select specific securities rather than make big regional calls, because it gives managers more control. “We are still in a long cycle that has not totally played out, so we have to look through the macro noise,” said Saunders. “Patient capital will be rewarded.”
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