Has Quantitative Easing Worked? A Two-Part Blog Series Perspective

Solomon-(2)Brad Solomon, Junior Investment Analyst

Part one in a two-part blog series discussing quantitative easing measures on a domestic and global scale.

As policy rates hover near (or below) zero, the focus has been on the timing and magnitude of rate hikes by the Fed and other central banks. Don’t worry, I’m not here to add my speculative voice to that crowded discussion. Instead, I want to provide a quick ex-post assessment of another tool that has left the spotlight after being largely phased out by the Fed. I’m talking about quantitative easing (QE)—the buying of massive amounts of financial assets—or large-scale asset purchases (LSAPs) as they are termed by some economists.

At its core, QE attempts to influence the supply and demand for financial assets, thereby shifting preferences towards spending and investment and away from saving. (For those interested in getting further into the weeds on QE’s theoretical underpinnings, check out Ben Bernanke’s 2012 Jackson Hole speech, Jeremy Stein’s remarks that same year, or this release by the IMF.) Among the U.S., U.K., Japan, and the ECB, the scope of QE to date has amounted to around 10-20% of 2014 nominal GDP. To put that into perspective for the U.S.’s case, that is about the magnitude of U.S. total federal discretionary spending over the trailing four years.

Solomon_QE_1

So, with the Bank of Japan and ECB contemplating expanding quantitative easing at their upcoming meetings, does the existing research generally conclude that QE globally has been a few trillion dollars well spent? Let’s take a closer look.

LSAPs have seemed to benefit U.S. equities unequivocally well, and international equities less so. Evidence on financial system vitality is mixed.

The algebraic explanation is relatively straightforward: the yield on risk-free securities is an element of the discount rate used to value stocks and other assets. Artificially keeping this rate low, as well as creating expectations that it will stay that way, increases the discounted present value of other financial assets. However, only in the U.S. has the annualized return of that country’s respective MSCI index over the past five years exceeded the return required by a general equity risk premium of 5.57% (from Fama & French, 2002) and country risk premiums as computed by Aswatch Damodaran of NYU (2015).

Solomon_QE_2

Evidence on QE’s ability to reduce stress within the financial system is mixed. Event studies show that QE announcements were followed by sharp reductions in financial stress indicators, which consist of variables including the TED spread, corporate bond spreads, and beta of banking stocks. However, some studies on Japan’s experience with QE assert that it took a substantial amount of time for bank lending to improve, as banks were burdened by nonperforming loans and uneasiness towards extending credit.

Solomon_QE_3

Furthermore, QE may have also distorted asset prices (some have gone far enough to use the term bond bubble) while creating “price-insensitive buyers,” a term used by Ben Inker of GMO to describe an investor for whom the expected return on the asset does not dictate their decision to purchase.

Look for part two of this blog series later in the week.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

2013 Review and Outlook

Amy MagnottaAmy Magnotta, CFA, Senior Investment Manager, Brinker Capital

2013 was a stellar year for U.S. equities, the best since 1997. Despite major concerns relating to the Federal Reserve (tapering of asset purchases, new Chairperson) and Washington (sequestration, government shutdown, debt ceiling), as well as issues like Cyprus and Syria, the U.S. equity markets steadily rallied throughout the year, failing to experience a pullback of more than 6%.

Source: Strategas Research Partners, LLC

In the U.S. markets, strong gains were experienced across all market capitalizations and styles, with each gaining at least 32% for the year. Small caps outperformed large caps and growth led value. Yield-oriented equities, like telecoms and utilities, generally lagged as they were impacted by the taper trade. The strongest performing sectors—consumer discretionary, healthcare and industrials—all gained more than 40%. Correlations across stocks continued to decline, which is a positive development for active managers.

YenDeveloped international markets produced solid gains for the year, but lagged the U.S. markets. Japan was the top performing country, gaining 52% in local terms; however, the gains translated to 27% in U.S. dollar terms due to a weaker yen. Performance in European markets was generally strong, led by Ireland, Germany and Spain.  Australia and Canada meaningfully lagged, delivering only mid-single-digit gains.

Concerns over the impact of Fed tapering and slowing economic growth weighed on emerging economies in 2013, and their equity markets significantly lagged that of developed economies. The group’s loss of -2.2% was exacerbated due to weaker currencies, especially in Brazil, Indonesia, Turkey and India. Emerging market small cap companies were able to eke out a gain of just over 1%, while less efficient frontier markets gained 4.5%.

Fixed income posted its first loss since 1999, with the Barclays Aggregate Index experiencing a decline of -2%. The yield on the 10-year U.S. Treasury began rising in May, and moved significantly higher after then Federal Reserve Chairman Bernanke signaled in his testimony to Congress that tapering of asset purchases could happen sooner than anticipated. The 10-year yield hit 3% but then declined again after the Fed decided not to begin tapering in September. It climbed steadily higher in November and December, ending the year at 3.04%—126 basis points above where it began the year.

TIPS were the worst performing fixed income sector for the year, declining more than -8%, as inflation remained low and TIPS have a longer-than-average duration. On the other hand, high-yield credit had a solid year, gaining more than 7%. Across the credit spectrum, lower quality outperformed.

Magnotta_Client_Newsletter_1.7.13_5We believe that the bias is for interest rates to move higher, but it will likely come in fits and starts. Rising longer-term interest rates in the context of stronger economic growth and low inflation is a satisfactory outcome. Despite rising rates, fixed income still plays a role in portfolios, as a hedge to equity-oriented assets if we see weaker economic growth or major macro risks. Our fixed income positioning in portfolios, which includes an emphasis on yield advantaged, shorter duration and low volatility absolute return strategies, is designed to successfully navigate a rising interest rate environment.

We continue to approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we begin 2014, with a number of factors supporting the economy and markets.

  • Monetary policy remains accommodative: Even with tapering beginning in January, short-term interest rates should remain near zero until 2015. In addition, the European Central Bank stands ready to provide support, and the Bank of Japan has embraced an aggressive monetary easing program in an attempt to boost growth and inflation.
  • Global growth strengthening: U.S. economic growth has been slow and steady, but momentum has picked up (+4.1% annualized growth in 3Q). The manufacturing and service PMIs remain solidly in expansion territory. Outside of the U.S., growth has not been very robust but is still positive.
  • Labor market progress: The recovery in the labor market has been slow, but stable. Monthly payroll gains have averaged more than 200,000 and the unemployment rate has fallen to 7%.
  • Inflation tame: With the CPI increasing only +1.2% over the last 12 months, inflation in the U.S. is running below the Fed’s target.
  • Increase in household net worth: Household net worth rose to a new high in the third quarter, helped by both financial and real estate assets. Rising net worth is a positive for consumer confidence and future consumption.
  • U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash that could be reinvested, returned to shareholders, or used for acquisitions. Corporate profits remain at high levels and margins have been resilient.
  • Equity fund flows turn positive: Equity mutual funds have experienced inflows over the last three months while fixed income funds have experienced significant outflows, a reversal of the pattern of the last five years. Continued inflows would provide further support to the equity markets.
  • Some movement on fiscal policy: After serving as a major uncertainty over the last few years, there seems to be some movement in Washington. Fiscal drag will not have a major impact on growth next year. All parties in Washington were able to agree on a two year budget agreement, averting another government shutdown in January. However, the debt ceiling still needs to be addressed.

However, risks facing the economy and markets remain including:

  • Fed Tapering: The Fed will begin reducing the amount of their asset purchases in January, and if they taper an additional $10 billion at each meeting, QE should end in the fall. Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, the economy appears to be on more solid footing.
  • Significantly higher interest rates: Rates moving significantly higher from current levels could stifle the economic recovery. Should mortgage rates move higher, it could jeopardize the recovery in the housing market.
  • Sentiment elevated: Investor sentiment is elevated, which typically serves as a contrarian signal. The market has not experienced a correction in some time.

Risk assets should continue to perform if real growth continues to recover, even in a higher interest rate environment; however, we could see volatility as markets digest the slow withdrawal of stimulus by the Federal Reserve. Valuations have certainly moved higher, but are not overly rich relative to history. Markets rarely stop when they reach fair value. There are even pockets of attractive valuations, such as emerging markets. Momentum remains strong; the S&P 500 Index spent all of 2013 above its 200-day moving average. However, investor sentiment is elevated, which could provide ammunition for a short-term pull-back. A pull-back could be short-lived should demand for equities remain robust.

Asset Class Outlook

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Asset Class ReturnsAsset Class Returns

Federal Reserve: To Taper or Not To Taper

Miller, Bill 2Bill Miller, Chief Investment Officer

Today, Ben Bernanke, current Chairman of the Federal Reserve, is expected to announce a decision on whether to taper or not to taper.  There are good arguments to taper, namely good employment growth and a budget deal between the Republicans and the Democrats.  Likewise, there are good arguments to not taper, including low inflation and the possibility of higher interest rates.  A key consideration for the Fed, should they decide to taper, will be interest rates.  More specifically, the Fed does not want long-term interest rates to increase suddenly.  We estimate that a sharp 1% increase in the long-term Treasury bond could cause as much as a 10% correction in the stock market.

Yesterday morning (December 17), ISI Group reported that the Fed will likely announce that there will be $400 billion left to buy in their Quantitative Easing program. This strikes us as a clever compromise between the taper or not to taper decision. Most importantly, it is not sudden.  Both the stock and bond markets will have time, probably five months or more, to measure the impact of tapering. Thus, we hope to stay long stocks for normal seasonal strength in the first quarter of the new year.  On the other hand, if the Fed announces a more sudden tapering exit, adding shorts to hedge stock market risk is a likely approach.

Monthly Market and Economic Outlook: December 2013

Amy MagnottaAmy Magnotta, CFA, Senior Investment Manager, Brinker Capital

U.S. equities continued to climb higher in November, with major indexes gaining between 2% and 4% for the month. Year to date through November, the S&P 500 Index has posted an impressive gain of 29.1%, while the small cap Russell 2000 Index has fared even better with a return of 36.1%. The last five years have proved to be a very good time to be invested in equity markets, with a cumulative return of 125% for the S&P 500 Index.

International developed equity markets posted small gains in November, and have failed to keep up with U.S. equity markets this year. In Japan, Prime Minister Abe’s policies have spurred risk taking, but the currency has also weakened. The European equity markets have benefited from economies and a financial system that are on the mend. Emerging markets continued to struggle in November and are negative year to date. Concerns over the impact of Fed tapering on emerging economies, as well as slower economic growth, have weighed on the asset class this year.

Interest rates have remained range-bound after the spike in the summer in response to Bernanke’s initial talk of tapering. The 10-year Treasury ended November at a level of 2.75%, just 10 basis points higher than where it began the month. Fixed income is still negative for the year-to-date period; the Barclays Aggregate was down -1.5% through November. However, high-yield credit has had a solid year so far, gaining close to 7%. We believe that the bias is for interest rates to move higher, but it will likely come in fits and starts.

12.13.13_Magnotta_MarketOutlook_2The Fed will again face the decision to taper asset purchases at their December meeting, and we expect volatility in risk assets and interest rates surrounding this decision, just as we experienced in the second quarter.  The recent economic data has surprised to the upside; however, inflation remains below the Fed’s target level. Despite their decision to reduce or end asset purchases, the Fed has signaled short-term rates will be on hold for some time. Rising longer-term interest rates in the context of stronger economic growth and low inflation is a satisfactory outcome.

We continue to approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we move into 2014, with a number of factors supporting the economy and markets.

  • Monetary policy remains accommodative: The Fed remains accommodative (even with the eventual end of asset purchases, short-term interest rates will remain near-zero until 2015), the European Central Bank has provided additional support through a rate cut, and the Bank of Japan has embraced an aggressive monetary easing program in an attempt to boost growth and inflation.
  • Global growth strengthening: U.S. economic growth has been steady and recently showing signs of picking up. The manufacturing and service PMIs remain solidly in expansion territory. Outside of the U.S., growth has not been very robust, but it is positive.
  • Labor market progress: The recovery in the labor market has been slow, but stable. Monthly payroll gains have averaged more than 200,000 and the unemployment rate has declined.
  • Inflation tame: With the CPI increasing only +1% over the last 12 months, inflation in the U.S. has been running below the Fed’s target level.
  • Increase in household net worth: Household net worth rose to a new high in the third quarter, helped by both financial and real estate assets. Rising net worth is a positive for consumer confidence and future consumption.
  • U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash that could be reinvested or returned to shareholders. Corporate profits remain at high levels and margins have been resilient.
  • Equity fund flows turn positive: Equity mutual funds have experienced inflows over the last two months while fixed income funds have experienced significant outflows, a reversal of the patter of the last five years. Continued inflows would provide further support to the equity markets.
  • Some Movement on Fiscal Policy: After serving as a major uncertainty over the last few years, there seems to be some movement in Washington. Fiscal drag will not have a major impact on growth next year. It looks like Congress may sign a two-year budget agreement, averting another government shutdown in January. However, the debt ceiling still needs to be addressed.

However, risks facing the economy and markets remain, including:

  • Fed Tapering: The markets are anxiously awaiting the Fed’s decision on tapering asset purchases, prompting further volatility in asset prices and interest rates. Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, the economy appears to be on more solid footing.
  • Significantly higher interest rates: Rates moving significantly higher from current levels could stifle the economic recovery. Should mortgage rates move higher, it could jeopardize the recovery in the housing market.
  • Sentiment elevated: Investor sentiment is elevated, which typically serves as a contrarian signal. The market has not experienced a correction in some time.

Risk assets should continue to perform if real growth continues to recover even in a higher interest rate environment; however, we expect continued volatility in the near term as we await the Fed’s decision on the fate of quantitative easing. Despite the strong run, valuations for large cap U.S. equities still look reasonable on a historical basis by a number of measures. Valuations in international developed markets look relatively attractive as well, while emerging markets are more mixed. Momentum remains strong; the S&P 500 Index has spent the entire year above its 200-day moving average. However, investor sentiment is elevated, which could provide ammunition for a short-term pull-back surrounding the Fed’s tapering decision.

12.13.13_Magnotta_MarketOutlook_1

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high-conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Asset Class Returns:12.13.13_Magnotta_MarketOutlook

The Next Chairman of The Federal Reserve Is…

Andy RosenbergerAndrew Rosenberger, CFA, Senior Investment Manager, Brinker Capital

In the study of various sciences such as physics, biology, or even economics, we often create models to help us better understand the world around us.  These models often start out simple and usually only account for a few variables at a time.  For example, when solving a physics problem, we may assume that friction doesn’t influence the movement of an object.  That may be an okay assumption if you were calculating the movement of an ice skater along the ice, but ignoring friction could have a devastating impact when discussing vehicle safety or sending a spaceship to the moon.  So too is the case with investments.  As investors, we often create models to try and explain the economic world around us.  For example, to explain the price of a stock or asset class, we may look to the future earnings power and discount rates to calculate a fair value.  But too often these models fail.  Just as many came to believe in the efficient market hypothesis theory, the 2008 financial crisis proved to be a wake-up call that the world of sociology and investor behavior is more complicated than even the most sophisticated models of today.

Since the failure of many traditional valuation models, many investors have shifted from a bottom-up-only view of the world to one that incorporates a more top-down approach.  Thanks in part to massive amounts of liquidity in the form of Quantitative Easing, Fed-watching has become a main source of the new top-down approach.  Unfortunately, leadership at the Federal Reserve remains in question and a seat change may be afoot again.  During an interview on June 18 with Charlie Rose, President Obama stated, “He’s [Ben Bernanke] already stayed a lot longer than he wanted, or he was supposed to.” The statement was a clear signal that new leadership will begin February 1 of next year.

Source: Zeorehedge.com via Paddy Power

Source: Zeorehedge.com via Paddy Power

Over the past month, the search for a new Fed Chairman has narrowed to an apparently short list of two candidates: Larry Summers and the current Vice Chairman of the Federal Reserve, Janet Yellen.  While many influential members of the economic community were quick to vocally support Yellen, the pendulum of consensus now appears to be forming around Larry Summers.  In fact, the nomination has garnered so much momentum in the financial community, that Paddy Power, a United Kingdom-based gambling site, is taking wagers on the outcome.  The current odds are fascinating, with Larry Summers a 1:2 favorite over Janet Yellen, with 2:1 (against) odds.  Amazingly, as charted by Zero Hedge, in less than a month’s time, Summers has moved from having an outside chance to being the favorite.  If you’re skeptical of foreign-based online gambling websites, even reputable sources such as Bloomberg put the odds of a Summers nomination at 60%[1].

What does this mean for investors?  Whereas the investing community largely expects a Yellen nomination to represent a continuation of the current monetary policy as directed under Chairman Bernanke, a Summers nomination is far more uncertain.  However, I’ll quote from one of our trusted research providers, 13D Research:

We have read everything that Summers has written in recent years and we suspect his views coincide very closely with that of President Obama. What makes this all so interesting is that Summers is a vocal supporter of fiscal expansion. It is highly possible that if he is nominated and confirmed by the Senate that he will push for a form of Overt Monetary Finance…Today’s Financial Times carries an article on Summers that quoted remarks he made about the effectiveness of quantitative easing at a conference last April. “QE in my view is less efficacious for the real economy than most people suppose…If QE won’t have a large effect on demand, it will not have a large effect on inflation either.” Summers also gave a highly optimistic outlook for the U.S. economy. “I think the market is underestimating the pace at which the Fed will alter its current course and the consequences of that for interest rates.” This means a radical change in the markets’ expectations. The article also emphasized the following: “People who have discussed policy with him say Mr. Summers regards fiscal policy as a more effective tool than monetary policy.” What has been lacking at the Fed is a strong personality and intellectual leadership. Summers is brash, intelligent and self-confident, traits which may enable him to take charge of the FOMC. A regime change of this order of magnitude would be a game changer of the highest order, impacting inflation, economic growth, wages, gold, and the U.S. dollar….

8.13.13_Rosenberger_NextFedChairman_1The jury is still out as to who will ultimately be the next Fed Chairman and what their policies will be.  Similarly, given that Summers represents a shift away from the status quo, his recent surge in garnering the nomination may partially be why markets have decided to take a breather.  After all, markets prefer predictability and quantitative easing has been a major tailwind for investor confidence.  Thus, we wouldn’t be surprised to see higher market volatility as investors adjust their models and conceptual frameworks to reflect the possibility of a new Federal Reserve paradigm led by Larry Summers.


[1] Bloomberg, http://www.bloomberg.com/news/2013-08-12/the-fed-race-heats-up.html

Market Commentary: Liquidity

Joe PreisserJoe Preisser, Portfolio Specialist, Brinker Capital

The powerful figure of the Federal Reserve Bank of the United States (Fed) continues to hold sway over the global landscape, as the collective eyes of investors around the world watch intently for any discernible hint of a shift in policy, which when detected, has radiated across the marketplace. During the course of the past five weeks, the American Central Bank has launched a veritable public relations barrage in an effort to stave off the steep sell-off in risk assets that accompanied comments issued by Chairman Ben Bernanke following the conclusion of a meeting of the Federal Open Market Committee on June 19.  During the ensuing press conference, Mr. Bernanke suggested that if the economic data from the U.S. continued in its current pattern of improvement, the time may be near for a measure of the support the Fed has provided to the U.S. economy. namely the $85 billion per month of asset purchases currently being made, to be curtailed.

7.26.13_Preisser_Liquidity_2Market participants reacted to the Chairman’s comments by throwing what has been called the “taper tantrum”(Bloomberg News), which culminated in a 4.8% decline in the Standard & Poor’s 500 over the course of five trading days, and a .35% rise in yields on the 10-year U.S. Treasury note during the same time frame.  The Central Bank’s officials, and especially the Chairman himself, have proven themselves particularly deft at quelling the market’s concerns in the day’s since, and in so doing have provided a catalyst that has sent stocks rallying around the world, and those listed in the United States to record highs. The volatility witnessed over recent weeks highlights the market’s continued dependence on the liquidity provided by the Fed, and further illustrates the difficulties surrounding its eventual removal, which may begin as early as September.

Reassurances from Fed officials—that the Central Bank remains committed to the continuity of its current accommodative stance for the foreseeable future—poured forth into the mainstream media as the selling pressure built within the marketplace. Beginning on June 25, the President of the Federal Reserve Bank of Dallas, Richard Fischer, and Minneapolis Fed President, Narayana Kocherlakota both issued comments designed to emphasize the fact that the Central Bank would keep in place its support of the economic recovery in the U.S. Mr. Kocherlakota was quoted by Bloomberg News on the 25th as saying, “The committee should continue to buy assets at least until the unemployment rate has fallen below 7 percent.  The purchases should continue as long as the medium-term outlook for the inflation rate remains below 2.5 percent and longer-term inflation expectations remain well anchored.” What have been categorized as unusually direct statements, of these two, non-voting members of the Committee (Bloomberg News), served to soothe concerns among investors, and were followed in short order by those of Richmond Fed President, Jeffery Lacker, who helped to further assuage any lingering uncertainty.  Mr. Lacker reiterated the fact that continued, substantive labor market improvement was necessary for the tapering of asset purchases to commence, and noted his confidence that deflation was not an issue (Bloomberg News), which helped to accelerate the rebound in risk assets.

7.26.13_Preisser_Liquidity_3The highly anticipated release of the June employment report was well received by the market. Although it revealed the creation of 195,000 jobs within the United States, which exceed the consensus estimate of 165,000 (New York Times), it fell short of the whisper number of 200,000 that had circulated, and the unemployment rate remained stagnant at 7.6%. The report buoyed the belief that the Fed would need to maintain its current pace of asset purchases for a longer period of time than many had feared as the pace of job creation, although improving, does not warrant tapering.  Jan Hatzius, the chief economist at Goldman Sachs, was quoted in the New York Times on July 5—“Beyond the headline numbers for job growth, it gets a little more mixed. There is still a lot of slack in the labor market.”

Stocks received a further lift from Chairman Bernanke who, in answering audience questions following a speech he delivered at the National Bureau of Economic Research conference on July 10, made an effort to stress the fact that the Central Bank remained committed to furthering the economic recovery.  Mr. Bernanke was quoted by the Wall Street Journal—“There is some perspective, gradual and possible change in the mix of instruments.  But that shouldn’t be confused with the overall thrust of policy, which is highly accommodative.” The Chairman once again reiterated this pledge in testimony before Congress on July 17—“Our intention is to keep monetary policy highly accommodative for the foreseeable future, and the reason that’s necessary is because inflation is below our target and unemployment is still quite high” (New York Times). These statements served to further the belief that has come to be known as the, Bernanke Put for the Chairman’s willingness to intercede when financial market’s struggle, which has been perceived to offer protection to investors, remains in place and provided further support to risk assets.

7.26.13_Preisser_Liquidity

Although benchmark indices in the United States have risen to record levels, a measure of uncertainty lingers beneath the surface as the inevitability of the scaling back of the Fed’s asset purchases remains, along with the question of who will succeed Mr. Bernanke as the next Chairman of the American Central Bank.  Despite no official word having been offered that his tenure atop the Federal Reserve will come to an end in January, this is widely considered to be the case.

Speculation as to who will replace Mr. Bernanke has risen to the fore with the two perceived leading candidates appearing to be the Fed’s current No. 2, Janet Yellen, and former Treasury Secretary, Larry Summers. According to the Wall Street Journal—“The race to become the next leader of the Federal Reserve looks increasingly like a contest between two economists: Lawrence Summers and Janet Yellen.”  In addition to the questions surrounding the identity of the next head of the Central Bank, a recent poll of economists, conducted by Bloomberg News, revealed the belief among a majority of those queried that the Federal Reserve would in fact begin tapering in September. With summer’s effusive glow illuminating Wall Street and the record gains of its equity markets, the cool winds of fall hold within them the possibility of bringing the unwelcome specter of volatility as these issues seek resolution.

Investment Insights Video: Responding to Rising Interest Rates

In May, Federal Reserve Chairman, Ben Bernanke, announced the possibility that they will begin tapering in the upcoming months. As that notion looms, so too does the prospective of rising interest rates.

We sat down with Bill Miller, Chief Investment Officer, and Jeff Raupp, Senior Portfolio Manager to discuss how Brinker is prepared to respond to the upcoming policy changes.  In this installment of Investment Insights, Bill and Jeff will give financial advisors and investors a clearer understanding of the tools available to Brinker Capital and how our portfolios can manage the impending environment of rising interest rates.

 

Should I Sell My Fixed Income?

Jeff RauppJeff Raupp, CFA, Senior Investment Manager

Now that we’re able to look back with the benefit of hindsight, it’s pretty easy to pick on the mistakes that investors made during the financial crisis of 2008. For instance, as equity markets sold off, emotion took over, and many investors that entered the crisis with a well balanced portfolio abandoned their plan and made wholesale changes to fixed income or, even worse, cash. At the time, it seemed like a rational reaction—Wall Street institutions that had existed for decades were insolvent, and each day seemed to bring a new, ineffective government program to stabilize the credit markets, along with yet another triple-digit loss in the stock market.

7.18.13_Raupp_FixedIncomeWe know now that what had started as an economic slowdown and then recession extended into a full-fledged market panic, where investors sold indiscriminately of price. In the years that followed, those that kept their heads recovered and reached new highs with their investments; those that joined the panic are, in many cases, still hoping to recover their 2008 losses.

Today, many investors are considering a question that could very much have the same negative long-term consequences, namely, “Should I abandon fixed income altogether?”

The question comes up after interest rates spiked in reaction to Federal Reserve Chairman Ben Bernanke’s May testimony in which he outlined a scenario where, with the right economic growth in place, the Fed could start lowering the level of bond purchases they’re making as part of the quantitative easing (QE) program. Over a two month period, the yield on the 10-year Treasury jumped from 1.6% to 2.8% and at -2.3%, the Barclay’s Aggregate Index had its worst quarterly return since the second quarter of 2004 when it fell 2.4%.

To answer the question, first let’s look at the downside potential. It’s been a long time since we went through an extended rising rate environment. As our research indicates, from 1945 to 1981 the yield on the 10-year Treasury rose from 1.5% to over 14%. Over that 36-year period, the return an investor in the 10-year Treasury received was actually a positive 2.8%, with 75% of the calendar years in that period having positive returns. The worst one-year loss, 5.0%, was in 1969, and the worst multi-year losing streak happened twice—1955-1956 and 1958-1959 (1957 was a strong year and the five-year period 1955-1959 was close to flat). Compared to a stock market bubble, the downside on fixed income is extremely tame.

7.18.13_Raupp_FixedIncome_1Secondly, you have to think about the role fixed income plays in your portfolio. In heavy stock market sell-offs, fixed income is often the only asset class with positive returns and therefore can act as a hedge against market volatility. Since 1945, there has only been one year (1969) where both stocks and bonds had negative returns. In today’s world, a global flight to safety results in demand for high quality fixed income, driving yields down and bond prices higher. No other asset class plays the low volatility hedging role quite as well. Responding to the threat of low rates by greatly increasing equity, or even alternative exposure, can prove disastrous if markets crater.

Finally, fixed income comes in many varieties. At any given point in time, there are areas of fixed income that provide opportunity and/or protection. By broadening your universe beyond simple treasuries to take advantage of these you can get a better end result.

Let’s be clear, core, investment-grade fixed income doesn’t provide a great investment opportunity right now. With yields still at low levels and likely to rise in the coming five to ten years, we’ll likely see muted returns at best with fits and starts of performance along the way. Inflation is currently in check below 2%, but if we started to see it flare up, investors, especially those with longer horizons, would need to consider the impact rising prices would have on their purchasing power. But even in an adverse environment, fixed income still plays an important role in portfolios.

Fed Likely to Remain Accommodative in the Near Term

Magnotta@AmyLMagnotta, CFA, Brinker Capital

Equity market investors expressed concern last week after the release of the minutes from the latest FOMC meeting suggested that the Federal Reserve is considering slowing down the pace of the current quantitative easing (QE) program. The Fed is currently purchasing $85 billion of U.S. Treasury and Agency mortgage-backed securities per month.

The Fed has changed its stance on when policy would potentially move to a tightening bias, from emphasizing a calendar date to basing it on economic data. The Fed has stated that it would not raise short-term rates until the unemployment rate fell to 6.5% as long as inflation is not expected to rise above 2.5%. With inflation currently running well below their threshold and with the unemployment rate elevated at 7.9%, it is likely the Fed is more focused on bringing down the employment rate, potentially at the expense of higher inflation.

With short-term interest rates already at the zero bound, the asset purchases are attempting to promote the same result as additional cuts to the fed funds rate. Even if the Fed tapers off their asset purchases in the next few months, any QE is still easing. They would just be taking their foot off of the accelerator. We feel that economic growth should remain tepid in the first half of the year and not strong enough to bring down the unemployment rate significantly, so the Fed is likely to keep their accommodative stance. In addition, the key members of the FOMC – Bernanke, Yellen and Dudley – all lean to the dovish side with respect to monetary policy.

Before actual tightening occurs, the Fed will first have to end QE. When the Fed stops asset purchases, it would be in the context of an improving economy. An improving economy is typically a positive for asset prices. As ISI Group shows in the following charts, equity prices have eventually increased in past episodes of policy tightening.

The Fed raised interest rates from 1.00% to 5.25% from June 2004 to June 2006. After a modest correction, equity prices moved up substantially.

The Fed raised interest rates from 1.00% to 5.25% from June 2004 to June 2006. After a modest correction, equity prices moved up substantially.

The Fed tightened in more aggressive increments during the 1994-1995 period. The equity markets moves sideways for a period of time, and then ultimately moved higher.

The Fed tightened in more aggressive increments during the 1994-1995 period. The equity markets moves sideways for a period of time, and then ultimately moved higher.

Balancing Act

Joe PreisserJoe Preisser, Brinker Capital

Concern lurched back into the market place last week, as the specter of an eventual withdrawal of the extraordinary measures the U.S. Central Bank has employed since the financial crisis, served to temporarily rattle markets around the globe. Although stocks rebounded smartly as the week drew to a close, from what had been the largest two-day selloff seen since November, the increase in volatility is noteworthy as it spread quickly across asset classes, highlighting the uncertainty that lingers below the surface.

Equities listed in the United States retreated from the five-year highs they had reached early last week following the release of the minutes of the most recent Federal Open Market Committee (FOMC) meeting as the voices of those expressing reservations about continuing the unprecedented efforts of the Central Bank to stimulate the U.S. economy grew louder. The concern of these members of the Committee stems from a fear that the current accommodative monetary policy may lead to “asset bubbles” (Bloomberg News) that would serve to undermine these programs. “A number of participants stated that an ongoing evaluation of the efficacy, costs and risks of asset purchases might well lead the committee to taper, or end, its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred. The minutes stated.” (Wall Street Journal).

Tangible evidence of the unease these words created in the marketplace could be found in the Chicago Board Options Exchange Volatility Index, or VIX, which measures expected market volatility, as it leapt 19% in the aftermath of this statement representing its largest single-day gain since November 2011 (Bloomberg News). The reaction of investors to the mere possibility of the Fed pulling back its historic efforts illustrates the continued dependence of the marketplace on this intervention and highlights the difficulties facing the Central Bank in not derailing the current rally in equities when it eventually pares back its involvement.

A measure of the uncertainty surrounding the timing of the Federal Reserve’s withdrawal of its unprecedented efforts to support the U.S. economy was dispelled by St. Louis Fed President, James Bullard, in an interview he gave late last week. Mr. Bullard, currently a voting member of the FOMC, was quoted by CNBC, “I think policy is much easier than it was last year because the outright purchases are a more potent tool than the ‘Twist’ program was…Fed policy is very easy and is going to stay easy for a long time.”

Reports of statements made by The Chairman of the Federal Reserve, Ben Bernanke, earlier this month, which downplayed the potential creation of dangerous asset bubbles through the Central Bank’s actions, released Friday, helped to further assuage the market’s concerns. “The Fed Chairman brushed off the risks of asset bubbles in response to a presentation on the subject…Among the concerns raised, according to this person, were rising farmland prices, and the growth of mortgage real estate investment trusts. Falling yields on speculative-grade bonds also were mentioned as a potential concern” (Bloomberg News). Although the rhetoric offered by these members of the Federal Reserve in the wake of the release of the minutes of the FOMC was offered to alleviate fears, the text of the meeting has served as a reminder to the marketplace that the asset purchases currently underway, which total $85 billion per month, will be reduced at some point in the future, and as such, has served as a de facto tightening of policy.

Though investors appeared to be appeased by the words of Mr. Bullard as well as those of Mr. Bernanke, the steep selloff that accompanied the mention of a pull back of the Central Bank’s efforts is a reminder of the high-wire act the Fed is facing when it does in fact need to extricate itself from the bond market.