NO. 1 ∙ January 2020
Don’t Fight the Fed! Again.
AUTHOR: Michael Blümke
Senior Portfolio Manager
Last month was the end not only of 2019, but of a whole decade. So it makes sense to place this Market Commentary in the context of a larger time frame.
Interestingly, some parallels can be drawn between the decade as a whole and the year 2019.
A high degree of uncertainty marked the beginning of both the decade and the year just ended. In 2010, shortly after the financial crisis, it was far from clear whether the worst (from an economic point of view) was over. Global capital markets were still licking their wounds and prices were still far short of their pre-crisis levels. It remained to be seen whether the resumption of economic growth was sustainable.
It was a similar story early last year. All optimism had disappeared after almost all asset classes recorded losses in 2018, due, for one, to the escalation of the global trade conflict. The fear that the economic cycle would soon end and the spectre of recession that this raised spread around the world.
A good ten years ago, an unprecedented large-scale fiscal experiment was launched in response to the financial and economic upheaval. In parallel with record-low refinancing rates, global central banks – first and foremost the U.S. Federal Reserve – paved the way for various phases of unconventional measures with their additional purchase programmes, thereby creating a decade of ultra-accommodative monetary policy. Thus not only was the recession brought to an end, but a long-lasting economic cycle and an impressive upward trend in stock markets was initiated as well. In time, the broad MSCI World Total Return Index climbed 147%, the yield on the 10-year U.S. Treasury fell from 3.84% to 1.88% and the yield on its German counterpart fell from 3.39% as far as -0.18%. In the course of these measures, the balance sheets of the three largest central banks quadrupled in size.
Figure 1: Balance sheets of the main central banks in billions of euros
A good ten years later, it was the attempt to successively end this experiment, for one, that brought an already cooling global economy closer to recession. The parallel with the beginning of the decade becomes particularly striking when one considers that once again, the active intervention of the central banks brought about a lasting stabilisation of the financial markets and economic growth. The unexpected and very abrupt shift by the U.S. central bank in 2019 from the tightening of monetary policy it had begun, back to easing, triggered a significant risk-on rally in almost all asset classes. A short time later, the fundamentals began to bottom out. Capital markets, and the equity market in particular, once again fulfilled their role as forerunner.
Again, a portfolio manager could be successful in both periods by applying the motto “Don’t fight the Fed”.
What does that mean in concrete terms for the coming year? What positioning should an investor adopt? On the one hand, we know that the central banks’ supportive stance will continue for the foreseeable future. On the other hand, a not insignificant portion of this monetary policy has probably already been priced in. The long-term interest rates remain at record lows despite the increase in the last quarter. The risk premium for corporate bonds of average quality has almost returned to the level it had reached prior to the 2008 financial crisis on both sides of the Atlantic. Equities, too, are valued at a multiple of the current and even future profits or revenues, which are at the high end of the valuation range in historical terms. From our point of view, however, these valuations at the extremes of observable historical data are not intrinsically bad. We do not think that values will directly revert to the mean after such an extreme. Rather, it is important to be aware of the current circumstances and, if necessary, query old dogmas that stem from an environment of moderate inflation and high growth. This does not mean that there will be no mean reversion on this occasion. In our analyses we, too, go by Mark Twain’s “History does not repeat itself, but it often rhymes”.
However, in the current environment the challenge is that the yield on the much-cited alternative investment – the virtually risk-free sovereign bond – has never been as low as it currently is. Thus there is no “history” for future events to “rhyme” with.
Figure 2: Yields on 10-year sovereign bonds
For this reason, it is all the more important to remain open even to scenarios that do not necessarily follow a familiar pattern. Anomalies must be played through to the end – or at least thought through to the end – taking into account the changing environment, which, in case of doubt, must be regarded as the new normal. What, for instance, does it mean for central banks’ interest rate policy when the national debt is already enormous in many developed countries? Not much, as long as debt grows at a slower pace than the economy. But what if that’s not the case? What happens if increasing populism ramps up current spending further and further – building up a debt mountain that will have to be reduced in the future – without stimulating economic growth? Without going into too much detail, it can be said that this aspect alone has far-reaching consequences both for interest rates and for capital market development.
For us as active portfolio managers, what we have to do is come up with short-term and long-term scenarios, and work their consequences for the various asset classes. When determining the subjective probabilities of the scenarios occurring, one must take care to avoid the usual pitfalls of behavioural economics. Is our attitude positive only because last year was positive (anchoring effect), or are we talking up the theories and looking for information to confirm them (confirmation bias)?
Looking ahead to the new year, which is also the start of a new decade, our main scenario tends to be constructive. We are acutely aware of the risks, which are no doubt numerous. However, we are confident that risks always go hand in hand with opportunities. For example, if interest rates fall further – which we expect in the longer term – equities have plenty of upside potential in terms of valuation alone. How much potential remains to be seen this year, and this decade.