March 30, 2012
These remain most interesting times. A well-established interrelationship has historically existed between the economy and the various asset classes that make up investment markets. But over the last several years since the outbreak of the financial crisis, this traditional harmony has fallen into discord. Why has this occurred? It is largely due to the persistently massive monetary policy interventions by the U.S. Federal Reserve (the Fed) and global central banks. And these policy contortions are likely to lead to continued market distortions as we move through the second quarter and the rest of the year.
The current economic outlook remains deeply challenged to say the least. Optimism about an economic recovery in the U.S. has started to predictably wane in recent months. Although data toward the end of last year was hinting at improvement, it was largely driven by the effects of businesses pulling spending forward into 2011 in order to take advantage of the accelerated depreciation fiscal stimulus program before it expired at the end of last year. But with this program now over, economic readings are once again on the fade as we slowly move toward a fiscal cliff at the end of the 2012. And the U.S. is not alone in its challenges, as growth is slowing across Asia and Europe has officially entered into recession while still battling against full-blown crisis.
The events of the first quarter highlight the distorting impact that monetary stimulus from global central banks has had on investment markets. A market environment defined by prudence and caution typically accompanies periods of economic deceleration and uncertainty such as today. This includes a stock market that is at best choppy if not in decline, as investors migrate away to the relative safety of more defensive asset classes. But since late last year, we have instead seen a market exhibiting near euphoric optimism that has included a stock market rising with little pause. This unusual outcome can almost exclusively be attributed to monetary policy actions by global central banks including the Fed and the European Central Bank (ECB), both of which have been fully engaged in stimulus activity since last October.
Markets driven primarily by monetary policy are prone to extreme risks. Put simply, when the Fed is stimulating, the stock market typically rises. But once the Fed stops applying stimulus, stocks almost immediately begin spiraling sharply lower. This is due to the fact that a stimulus driven market is not rising based on sustainable fundamentals. Instead, it is floating higher on monetary adrenaline to levels that the current economy simply cannot support. And once this adrenaline is removed, stocks immediately begin moving to find their true fair value, which unfortunately is much lower than where the market is currently trading. This helps explain why the stock market fell so swiftly starting in April 2010 and July 2011, as both of these episodes began exactly two weeks after the end of the Fed’s last two stimulus programs.
Thus, the future direction of the stock market will be highly dependent on Fed policy. The current Fed stimulus program known as Operation Twist is scheduled to end in June 2012. This fact alone will greatly impact the stock market outlook both for the second quarter and the rest of the year. Given that the stock market has already risen sharply in recent months and the ECB has now completed it scheduled Long-Term Financing Operations (LTRO) it is likely that we could see the stock market grind back and forth for much of Q2 just as it did last year before the end of QE2 back in June 2011. But if the Fed allows Operation Twist to conclude without any additional stimulus planned, a sharp stock market correction starting in mid to late July would be likely. However, it is possible that the Fed might seek to launch a new stimulus program (“QE3” or “Operation Twist 2”) at the beginning of July. This has the potential to sustain stocks at current levels if not provide an additional boost to the upside in the second half of the year. For these reasons, monitoring the Fed’s words about its next policy movements if any will be particularly important as we move through the second quarter.
It should be noted that the Fed is facing some critical challenges in trying to apply any further stimulus going forward. First, the stock market has not been the only thing that has been lifted by Fed stimulus, as oil and gasoline prices have also been propelled higher even more so than stocks. If the Fed opts for additional stimulus, they risk increasingly crushing the economy under the growing inflationary weight of rising energy costs and gas prices at the pump. Second, the threat of crisis in Europe continues to mount, with problems increasingly impacting major economies such as Spain and Italy. Even if the Fed continues to pour on stimulus, the problem in Europe may soon overwhelm the Fed’s efforts. Lastly, the Fed faces a potentially tricky situation politically in the second half of 2012 due to the Presidential election. Historically, the Fed has sought to step aside from policy action during the election season, so any policy actions they do or do not undertake will likely face close inspection in the coming months. All of these are factors that also warrant close attention going forward.
Current portfolio strategy continues to emphasize navigating these policy and market risks in the months ahead. A continued allocation to the stock market is warranted given the continued monetary adrenaline scheduled for the coming months. But given the policy toxicity that is impacting the market, it remains prudent to keep these exposures to weights that are proportional to other asset classes. Moreover, specific stock positions remain focused on the more defensive areas of the market including Consumer Staples and Utilities. Not only are these names more likely to hold up better during any market pullback, but they have also underperformed notably in recent months and are overdue to move back in line with the overall market if it continues to rally.
Of course, the stock market is just one of many asset classes available in the market today. And in terms of these various other categories, the priority remains on selecting those asset class that have shown the propensity to rise regardless of the events impacting the stock market and applying them in a portfolio construct that balances risk with long-term upside potential. These include U.S. Treasuries and TIPS, Agency MBS, Municipal Bonds, Corporate and High Yield Bonds, Precious Metals such as Gold and Silver, selected Real Estate, selected Currencies, Cash and Cash Equivalents, and Volatility. At present, this includes strategies that are only 40% positively correlated to the stock market, with another 45% uncorrelated and the remaining 15% negatively correlated. This also includes striking a balance between inflationary risks (if the economy recovers) and deflationary risks (if the economy falls into recession). Given the current economy, this includes a 40% weight to inflationary assets, a 40% weight to deflationary positions and the remaining 20% to price neutral allocations.
As discussed in my recent announcement on the new GWM communications platform, I will be following up this Q2 outlook over the coming weeks with additional posts providing detail on the various portfolio positions discussed above and the underlying strategy and expected time horizon associated with each.