In the midst of any foggy economic phenomenon, it’s difficult for an industry to really assess how it’s being affected. But with time comes clarity, and it’s now possible to look back on the past eight years of Fed policy and draw broad conclusions about how Quantitative Easing actions created headwinds for investors in the managed futures space. Crucially, these conclusions give us a reason to feel optimistic looking toward 2017 and the return to a world of abundant, varied trading opportunities.
We have been meaning to write an in depth report on central bank policies for some time and the market responses to recent BoJ policy decisions as well as the Fed meeting and press conference this week have nudged us to make a start. Below are some initial thoughts on how good central banks are in their forecasts and where they may take us in the future. We don’t mean this to be a rant, but it’s hard to discuss central banking politely when they have been so ineffective, when they refuse to accept they have been incorrect and they refuse to fully acknowledge the full unintended consequences of their hugely experimental policies.
The most obvious and immediate European problem is the UK’s Brexit vote on 23rd June, and momentum has clearly swung away from the remain camp in the last two weeks. What was seen as only a minor risk for financial markets has quickly become a huge potential risk and prices have begun to adjust. In our opinion, this is not just an issue of migration but a problem of the average man on the street simply does not feel that their lives have improved materially since the Global Financial Crisis. There are a huge number of voters who feel completely disaffected and simply want change. This is not an issue unique to the UK. Huge numbers across Europe and the US are in the same boat and the risk of a series of anti-establishment votes in the next year or so is growing.
After a truly disappointing US employment report, the market has priced out any rate hike in coming months, with only slightly more than a 50% probability of one rate rise by year end. In our opinion, Janet Yellen has always been a lot more dovish than a number of her colleagues and will not want to raise rates now. So, either the Fed ignores the poor US employment report (and the continuing weakness in the manufacturing sector and corporate profitability) and raise rates anyway, thereby risking upsetting the financial markets. Or, they shift back to a more dovish narrative, risking their credibility.
The general rule of thumb in equity investing is that you do not Fight the Fed, and there is a lot to be said for that thesis. Naturally, one has to respect the idea that higher rates provide more competition for equities in the traditional equity/bond portfolio, and vice versa when rates are low. I have actually spent, who knows how many, hours trying to model equities vs interest rates and I learned several lessons in the process. Primarily that rates high and rising are indeed not conducive to higher equity prices. However, rates low and rising are not as reliably equity unfriendly. And one can make a case that rates Low and rising are initially actually very good for equities. My studies suggested a high correlation between equities and rates when rates were high, not as much when rates were low.
The Fed’s normalisation process has been a tortuous on/off affair primarily because their focus has been almost entirely on not upsetting the financial markets rather than doing the right thing for the long term health of the US economy. This week, the Federal Reserve machine cranked into action to persuade markets that they want to raise rates before the Summer and again before year end. So far, the reaction has been quite muted, but it is far from certain that this calm veneer will continue. Let’s dive in and think about what the Fed are doing and what this means for markets.
As most of us know, trying to predict financial markets is frustrating nearly all of the time, and downright impossible too much of the time. Part of the problem is that everyone wants instant gratification. As money managers, we are delighted when our trades become immediately profitable and frustrated when they don’t. The same goes for all market participants regardless of individual timeframes.
“Bracketology”, a term coined by ESPN, is the study of the annual NCAA college basketball tournament. Interestingly the art or science of filling out an NCAA tournament bracket also provides insight into how investors select investment assets. Before explaining, we present you with a question: When filling out an NCAA bracket do you A) start by picking the expected national champion and work backward or B) analyze each matchup, and pick winners starting at the earliest rounds, working toward the championship game?
The Absolute Return (AR) series of articles provides a primer on alternative investment styles to which few investors have access. Global markets and economies appear to be at the precipice of a paradigm shift making the timing of the AR series of unique value. In the 7 years since the financial crisis, most asset prices have experienced significant appreciation allowing for even the most inexperienced investor to increase his or her wealth. As the saying goes, “a rising tide lifts all boats”. For investors, understanding the tide of financial momentum is extremely important. Accordingly, we summarize 4 primary drivers of past returns to help gauge whether the tide can continue to rise or if retreat is more likely.
Absolute return strategies aim to generate positive returns irrespective of market direction. A truer more apt definition is that absolute return, or active investment management, seeks at all times to minimize losses. We mentioned this as a core attribute of an absolute return strategy in “Why an Absolute Return Strategy”, but this simple concept is worth further description.
The first goal of investing is to increase wealth or said differently, to increase purchasing power. Warren Buffet is quoted as saying “Rule number 1 of investing is never lose money. Rule number 2 is never forget rule number 1.” The hidden message in these seemingly obvious statements is that building wealth depends much more on preventing large losses than it does on achieving large gains.
Part 2 of our series on bonds “Bonds – Is Credit Growth Hitting its Limits?” discussed the likelihood that the demand to borrow could stay weak, keeping the demand curve from shifting right and therefore playing an important role in keeping a lid on higher interest rates. In this final article of the series we focus on factors that investors should consider to help gauge demand for bonds.