Winston Churchill once said “I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key.”
This quote could be a pertinent comment on the Federal Reserve’s current policy.
The year started with a cosy consensus on the expected path of markets. In essence, developed market equities would perform in line with earnings (circa 9 per cent), emerging market equities would continue to struggle as they tried to solve past excesses, developed market bond yields would generally face upward pressure, and commodities were best avoided.
Positioning among fund managers seemed very much aligned with this view.
However, the first quarter saw most contrarian positions offer far superior returns. Most noticeably, investors almost seem to be in denial over the strength of developed market bonds.
Market participants appear confused and highly sensitive to evidence that confronts their expectations. This has resulted in marked rotations that confound the consensus. Much of this emanates from the effects of existing unorthodox policy measures – not least of which is the sub-par nature of the recovery and the lack of inflationary pressure in most developed economies.
In our opinion, the Fed’s policy statements have created further complications to an already confusing picture. On March 19, chairwoman Janet Yellen clarified the Fed’s thinking on a range of issues. The statement that the Fed would “maintain the current target range for the Federal funds rate for a considerable time” garnered most attention, as she clarified that this was probably around six months.
A sharp adjustment to interest rate expectations followed, associated with violent reactions in US bond and equity markets.
Equally, this marked a sharp rotation in style performance, with previously high-flying growth sectors such as biotech and social networking suffering large falls close to 15 per cent and 13 per cent, respectively. Commentators claimed that overvaluation was the prime driver as investors factored in the effect of earlier rate rises on net present value/discounted cashflow calculations, as well as change to a ‘risk off’ attitude.
While we accept these factors played their part, our sense is that deeper processes have been at work. Investors have been trying to price in the transition to a new environment and, with it, policy certainty. In our opinion, this certainty was removed on March 19.
Bonds and equities are pricing in two very different effects, and our general bias is to think about the scenarios in which these would be resolved. While short-term economic indicators may be strong in response to pent-up demand caused by extreme weather, we question whether this is sustainable.
We question whether the Fed is making a mistake in thinking that tapering is not tightening and at heart is very confused. If the trend of economic improvement is shallower than expected and the Fed has to signal further changes, markets are likely to react violently.
The key is the growth rate of the US economy; but the Fed’s credibility rests on getting this right. If policy settings are incorrect, we may witness a moment of reckoning similar to 2011.
Mark Harris is head of multi-asset at City Financial
