Markets are nervous about losing the monetary stimulus punchbowl. How you can prepare for higher volatility.

Monthly Investment Letter

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Even as the temperatures outside cool, the debate among policy makers has become more heated. Bank of England Governor Mark Carney has gone so far as to suggest that the path to negative rates was the “wrong” route to take. The Bank of Japan (BoJ) decided at its September meeting to refrain from pushing rates deeper into negative territory. At the same time it unveiled novel stimulus policies, which suggests that sub-zero rates may be going out of fashion.

A consensus has begun to emerge that a world of more active fiscal policy, in which finance ministers take greater charge of economic management, may lie on the “other side” of the monetary attempts to stimulate growth. Even in Europe, the idea of deficit spending is becoming less taboo. European Commission President Jean-Claude Juncker is reportedly considering plans to relax and simplify the Stability and Growth Pact, the set of fiscal rules designed to limit spending among EU member countries.

The prospect that debates about the efficacy of monetary stimulus might lead to the punchbowl being taken away has provoked rising market volatility after a period of summer calm. Importantly for portfolios, it has also resulted in rising correlation between stocks and bonds. Correlations are now close to their highest levels in five years (Fig. 1), making portfolios more vulnerable to increased short-term volatility.

One investor response has been to seek safety in cash, with average investor proportions of it rising to 5.5% from 5.4% in the most recent BAML Global Fund Manager Survey.

Positive correlation poses a threat to diversification.

Central banks are staying but shifting

If you think that central banks will give up on stimulus measures tomorrow, then a well-timed move out of a diversified asset allocation and into cash makes sense. In my view, central bank questions about monetary policy will lead to a new phase of stimulus, but not less stimulus.

The BoJ might take away the punchbowl, but not until the cups of sake have been poured.

When I started investing, “prudence” from a central bank meant a willingness to raise interest rates sooner rather than later. Now, according to the US Federal Reserve’s Lael Brainard, it means keeping them lower for longer – a strategy that the Fed followed by staying on hold at its September policy meeting.

While policy makers are right to question the efficacy of some of the more unorthodox policies – such as negative rates and quantitative easing (QE) – central banks will continue to pursue these and other measures. For example, the BoJ has continued to innovate, introducing commitments to “overshoot” its 2% inflation target and to cap 10-year bond yields at zero. It might take away the punchbowl, but not until the cups of sake have been poured.

There are at least two important considerations for investors to entertain as we enter what may become a new phase of stimulus efforts:

1) The global policy war on cash is far from over. Investors should prepare for even more negative real yields on cash if inflation rises. With oil unlikely to fall 35% again as it did last year, and with the US close to full employment, inflation can trend higher. Most US inflation gauges are already at or above their 20-year averages. Top money managers participating in our Investor Forum this month expressed their belief in a firmer inflation outlook. It is also worth noting that some serious economists want to increase the war on cash in other ways – calling for its abolition – so that monetary policy making and law enforcement efforts are more effective.

2) bonds look increasingly at risk. The rally in government bonds this year has been supported by negative interest rate and QE policies that may now be reaching their limits. We’ve seen sharp sell-offs in recent weeks, particularly in the UK and Japan (two countries currently pursuing bond buying but where central bank chiefs are clearly uneasy about going further). Such market moves demonstrate the potential risks for bonds if loose monetary policy is shifting focus from bonds to other assets or measures.

Where cash and bonds have low to negative yields, we have to work harder to find higher returns.

What are the alternatives?

Cash and bonds have historically been important components of a diversified portfolio, but they may be getting even more costly to hold as “insurance.” In a world where cash and bonds have low to negative yields, we have to work harder to find lower volatility, diversification, and/or higher returns.

We believe that alternatives – hedge funds and private markets – are worth allocations.

Hedge funds

• Hedge funds are unlikely to deliver the kind of returns they did before the financial crisis; the industry has expanded and competition for alpha is high.
• But they still provide effective portfolio diversification, and returns still compare favorably with other assets in a strategic allocation.
• And the best managers are still able to seize opportunities in more opaque markets, and even in sideways or down-trending markets.

Private markets

• Managers of private markets funds have the flexibility to buy assets and add value in illiquid markets.
• They can more easily take advantage of mispriced assets as information may not be readily available or disclosed to average investors.
• Private markets have also proven their ability to diversify returns in periods of equity market turbulence: compared to the average of the 10 worst drawdowns for public equities over the last decade, private market indices have been more resilient (Fig. 2, although we should note that public and private market returns are not directly comparable given different industry standards for presenting performance).

Private markets have historically held up better when listed stocks are falling.

Tactical asset allocation

Over our six-month investment time frame, we remain positive on risk assets.

Volatility has risen in the short term as the policy debate has gotten louder, and there are a number of political and economic risks ahead. However, as we saw with the Brexit vote shock, policy action and economic growth are likely to prove a stronger driver of markets in the medium term.

On the economic side, we continue to monitor Chinese data and Fed policy closely.

Headline growth in China has been good, but balance sheet strains remain – debt is rising, house price growth is extreme in some cities, and financial sector pressure points came to the fore again as Hong Kong interbank rates spiked.

While we believe the Fed is likely to remain cautious over the long-term horizon, varying market interpretations of the path of Fed rates could lead to higher short-term volatility, similar to that seen in recent weeks.

A number of political risks also loom between now and next year’s 19th Party Congress in China, the biggest being the US election. A Donald Trump victory is not priced in to markets and would likely cause marked short-term volatility. A Trump win is not our base case. We will continue to track the US election campaign in our Election-Watch series.

Despite these and other risks, we are overweight US equities against government bonds because they are less expensive, less vulnerable, and have greater upside, in our view.

The earnings yield of stocks relative to Treasuries has only been higher 16% of the time since 1956 (Fig. 3). As current bond-buying measures are increasingly being questioned, government bonds are vulnerable to sharper drawdowns.

Relative valuations favor US stocks over govenment bonds

And we see clear catalysts for US equity gains: the earnings drag in the US from lower oil prices and a stronger dollar is abating, and we expect earnings growth of 3% this year overall, which should accelerate to 6.5% next year.

We are overweight emerging market equites versus Swiss equities.

Profits are starting to stabilize in emerging countries after a multi-year malaise. The turnaround should be fueled by reviving economic momentum. Gauges of business activity show manufacturing activity expanding.

And with the Fed still in go-slow mode, emerging market currencies have rallied, further reducing inflation pressures and the need for tighter monetary policy.

Meanwhile, Swiss stock indices are skewed toward defensive sectors, and are less well positioned to exploit a global earnings improvement in more cyclical sectors.

We favor the Norwegian krone versus the euro.

Norway is arguably more advanced than most other regions in as much as it has generated high inflation – currently running at 4%. We believe this means its central bank’s easing cycle is clearly over, a view supported by the more hawkish tone of the Norges Bank’s September meeting.

We are introducing a new position on a basket of emerging market currencies – Russian ruble, Brazilian real, South African rand, Indian rupee – versus a group of G10 currencies – Australian dollar, Canadian dollar, Swedish krona.

The goal of this position is to take advantage of the interest rate differentials between these nations which currently amounts to roughly 8% p.a. We prefer a basket of currencies in order to limit the overall risk of the trade. Taking this position during a time of improving economic conditions limits the danger of weakening emerging market currencies.

And the low-yielding developed currencies we have chosen to underweight share a high exposure to commodities and/or the global economic cycle. As a result they should diversify the risk of the EM basket.

Conclusion

The debate over the right balance between monetary and fiscal policy has grown louder in recent months, contributing to higher volatility. I believe policy support is likely to remain firmly in place for the foreseeable future, even if the means of implementation shift.

Cash and bonds are at risk in this environment, and investors will be required to find more creative ways to seek safety and diversification over the longer term.

Over the short term, I maintain a positive view on risky assets. Loose policy and earnings growth should offset potential risks, and we are staying overweight equities relative to bonds in our global tactical asset allocations.

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