Investors have had to endure much more volatility in the past few weeks. We may know why — the Federal Reserve put an expiration date on its $3 trillion-plus bond-buying program. But some investors don’t know how to proceed.
The Fed’s easy-money policy — mainly known as quantitative easing, or QE — probably will end next year. The central bank, after all, said it may start to taper the program later this year.
Investors have begun to think about the consequences. But economies and markets are interconnected, and one rain drop here can lead to a hurricane elsewhere.
|You have to think about central banks’ experimental economic concepts to position your investments successfully.|
To begin to understand what is happening, consider the bond market. Bonds have been in a bull market since the early 1980s, when the world’s central banks instituted policies to reduce high inflation. As a result, bond yields have been on a steady, but erratic, march down. It now seems likely that yields have reached their lows with no room to move down further.
This means that bond prices have probably peaked. Indeed, they likely reached their highest levels several weeks ago. Since then, turmoil has spread through global fixed-income markets, demonstrating that an adjustment is under way. Other indicators from the bond world point in the same direction, with the spreads on most fixed-income instruments rising sharply as measured against comparable government securities.
Looking beyond the developed world, emerging-market bonds and currencies have been especially hard hit as so-called “carry trades” are unwound. A “carry trade” is shorthand for what people do when they are trying to pick up bigger yields.
As an example of a “carry trade,” an investor might borrow in dollars, say, at 1 percent and lend in Brazilian reals at 8 percent. The additional yield is known as the “carry” and is based on the twin assumptions that the Brazilian currency will be stable and that dollar borrowing costs will stay low. Currently, both of these assumptions are being tested, and a lot of the recent volatility in the markets has been influenced by this.
In equity markets, there has been a sharp sell-off anywhere that’s perceived as risky. Emerging markets have slumped, as have commodity prices and peripheral Europe.
Turkey, Brazil, and Egypt have undergone various degrees of social upheaval. Chinese growth has slowed noticeably, with the government beginning to clamp down on lax banking practices and excess credit creation. And peripheral Europe remains peripheral, with a generation of young people consigned to the scrapheap.
The price of gold has collapsed in line with other commodities, as investors have been forced to recognize the likelihood of slower growth in the emerging world. Plus, the reality is that economies there will be less commodity-intensive as the focus turns to consumers instead of grand-capital-building projects.
In the background, companies have been living in an unstable paradox. Sales have rebounded less than in any post-war period of economic recovery. The corollary is that interest costs are at rock bottom as is labor’s share of profits. Ironically, this means that corporate financial health has benefitted directly from the anaemic global economy and the resulting policies.
This is an inherently unsustainable situation as companies, as a whole, require greater prosperity in the population to boost sales. This is also the stuff of social unrest as the main beneficiaries of QE have been those that hold assets and control capital. The potential for the kind of protests we have witnessed in Brazil and Turkey isn’t limited to emerging markets, although it may take the milder form of political banker-bashing and corporate-compensation caps in the U.S. and Europe.
Is it suddenly all that bad? Not in my view. My central thesis has been, and remains, that economic growth will be sluggish and inflation subdued as the developed world works off the debt overhang from the binge of the previous couple of decades.
This, combined with a weak banking system, has meant that interest rates have been lower than is justified by inflation, and this is likely to be the case for the foreseeable future. Nothing has changed all that much because interest rates, although rising, are likely to remain below their historical average for a long time.
The analysis above is a long way from the real world in which you live. It is unfortunate that you have to think about central banks’ experimental economic concepts in order to position your investments successfully.
In this environment, stick with a balanced approach both within and across asset classes. In your bond holdings, reduce what is known as “duration risk.” Duration is a measure of the length of maturity of a bond, and the longer it is, the more the price will fall if interest rates rise. At this stage, you should minimize duration and emphasize higher-yielding assets exposed to floating rates.
In equities, spread your wealth across the globe, particular to companies that have high-quality businesses.
Despite recent declines, maintain a position in gold because it is an insurance policy against the failure of central banks to deal adequately with the world’s problems.