CAPTRUST Chief Investment Officer
I could see the train wreck take shape in slow motion. My wife Jamie’s birthday is September 30, and as I opined in this column four years ago this very quarter, birthdays are a big deal at the Freedman house. While Jamie is not one for drawing attention on her birthday, she puts up with a lot given my hectic work schedule, so our three kids and I really focus on her day. Since I had to be at a client meeting two plane rides away the morning of her birthday, I flew out the Sunday before and was slated to return well after dinner on her actual birthday. Business travel before and during her birthday was the first part of the train wreck, and the potential for market-impactful Washington shenanigans was the second, which increased as the government’s fiscal year-end approached with no continuing resolution to avoid a full or partial government shutdown. Of course, the continuing resolution deadline fell on Jamie’s birthday.
Given my lack of physical presence that Monday, I had to prepare well in advance and build in contingencies. I got some presents, secured a cake, and gathered the kids’ homemade birthday cards. Perhaps the variable I was most excited about was plotting how Conner, my 6-year-old son, would deliver fresh flowers to Jamie that Monday morning. Just before I left for the airport, I bought a bouquet and hid them in a secret spot in his room, where the flowers would remain out of Jamie’s sight. Conner was to give them to Jamie when she woke him up for kindergarten the next morning. Should my flights get delayed or canceled, Jamie would at least have some items representative of our affection for her. Given the circumstances, our kids and I agreed that this was about as creative as we could get.
In the vein of creativity amid uncertainty, global central banks, including the U.S. Federal Reserve, have been forced into some unconventional thinking about how to steady the broad economy, both during and since the global financial crisis. We see central bank policy as the single largest market driver across asset classes, and we do not see that abating for some time. Despite historians’ attempts to compare the crisis with past financial calamities like the Great Depression, the global economy is fundamentally very different now, due to globalization and vastly different industrial and political structures. Central bank leaders like the Fed’s Ben Bernanke and Europe’s Mario Draghi have drawn from past crises, but the playbook is very different today. Accordingly, our investment strategy needs to take into account which central bank policy choices may materialize and their resultant impact on asset classes.
The Fed has three objectives when it enacts monetary policy, defined as actions that central banks take to achieve their economic goals (compared with fiscal policy, which refers to spending and tax policy set by the federal government): achieving maximum employment, fostering price stability, and moderating longer-term interest rates.1 These are lofty goals, and the financial crisis proved to be a stern test for the Fed and other market agents; prices plummeted, unemployment moved higher, and longer-term interest rates dropped by almost half from crisis onset to the proverbial eye of the storm. The Fed’s response was indeed creative, deploying three toolsets to offset economic morass: short-term loans for private banks and other central banks, injecting liquidity directly into credit markets (for example, money market funds within retirement plans), and finally, using more conventional central bank tools to buy securities in the open market in an attempt to hold down borrowing costs.2 These tools were used at times in conjunction with other global central banks (particularly during the crisis’ height), in other periods independently, and at times to the chagrin of other central banks worried about how Fed policy may indirectly affect them.
Fed critics claim that Chairman Bernanke and colleagues have overstepped their monetary policy boundaries. Even Warren Buffett (famed investor and one-time lunch companion of yours truly) called the Fed “the greatest hedge fund in history” at a September event with students, highlighting the Fed’s largesse and ability to generate revenue for the U.S. government through its bond purchase programs.3 Whether one agrees with Mr. Buffett’s characterization or not, the Fed’s size cannot be disputed; through purchasing treasury and mortgage bonds, its balance sheet has increased from $869 billion in August 2007 to more than $3.7 trillion in October 2013.4
Many investors suggest the Fed has limited policy options remaining, considering the size and total time committed thus far, leading them to conclude that the Fed has a very small overall impact in markets today. We disagree, based on market evidence from the end of September. Heading into the Fed’s mid-September policy meeting, most everyone expected the Fed to announce a slowdown from its current $85 billion per month bond buying program given economic data as well as Fed posturing before this meeting and ensuing press conference. However, the Fed chose to continue bond buying at then-existing levels, resulting in the largest intraday price swing in the U.S. bond market in more than two years, based on CAPTRUST research. Markets would not have reacted as sharply if the Fed did not carry market gravitas, thus solidifying our view that Fed policy still dominates asset class movements.
The Fed is not alone in its creative thinking. The Bank of Japan has also radically altered its approach to monetary policy, and while its only focus is price stability, recent policy actions have jolted the Japanese economy and capital markets in an attempt to, in the Bank of Japan’s own words, “lead Japan’s economy to overcome the deflation that has lasted for nearly 15 years.”5 The European Central Bank (ECB) has also been forced to think in unconventional means; however, the ECB has been unable to wield as aggressive a posturing as Japan and the U.S. due to political differences across European countries about the correct pan-European response. Irrespective, ECB President Mario Draghi has successfully staved off bond market upheaval in challenged economies like Portugal, Spain, and Italy based on a now infamous pledge to do “whatever it takes to preserve the euro. And believe me (Draghi), it will be enough.”6 Even the UK has gotten in on the unconventional thinking act, importing former Canadian central bank head Mark Carney as the new Bank of England governor.
We see creative thought continuing to evolve, and our market views will be shaped by Fed and global central bank policy. As you can see in Figure One, the Fed faces a conundrum: a growing yet sluggish economy, jolted by trillions of stimulus dollars yet still not reflecting inflationary pressures normally expected after stimulus of such magnitude and duration. Figure One includes a reading from the CRB Index, which measures a broad basket of commodity prices, the Personal Consumption Expenditure (PCE) Index, a favored Fed gauge of household products and service costs, and 3-year breakevens, which reveal forward inflation expectations vis-à-vis bond prices.
All three measures remain subdued due to economic growth indices reflecting an abnormal economic environment relative to expectations this far into a recovery. Given this outcome, the Fed and other central banks are unlikely to remove stimulus for a long time.
So, what to do amid a capital market backdrop dominated by central banks? We believe having a variety of return sources in portfolios is the best path forward. We remain enthusiastic about global stocks, particularly those geared toward long-term secular growth that take advantage of demographics largely unaffected by economic ebbs and flows as well as those with valuation support. While interest rates are low by historical standards, political division could hurt riskier asset classes, making parts of the bond market attractive in the near term. However, investors in traditional bond sectors like treasurys and mortgages should continue to expect lower returns than experienced in recent years. Our investment committee, utilizing work done by teammate Hunter Brackett, emphasizes that investors seeking greater portfolio returns must be prepared to accept higher levels of portfolio volatility found in riskier asset classes, thanks to low bond yields. Once the Fed begins to slow its bond market purchases and eventually stop, bond prices could face some challenges.
As for Jamie’s birthday, the flower plan worked like a charm. Conner woke up and got himself dressed for school before Jamie had a chance to wake him, and upon opening his door, there was her baby boy, holding a vase full of flowers with a proud smile on his face. I reminded Jamie of that image when I told her at about 9 pm (a full 90 minutes after I arrived home) that I had to watch C-SPAN for the rest of her birthday night as Congress could not compromise and avoid a partial government shutdown. She smiled and nodded nostalgically as she handed me my pillow.
As creatively as I tried to position myself, sleeping on the downstairs couch was particularly uncomfortable that night.
5 Bank of Japan Statement on Monetary Policy, October 4, 2013, available at http://www.boj.or.jp/en/mopo/mpmdeci/state_2013/index.htm/
6 Mario Draghi speech to Global Investment Conference in London, July 26, 2012. Available at http://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html