Not only is the Federal Reserve speeding up the rate of quantitative tightening, it is also showing no signs that it is ready to change its aggressive tightening policy.
The most dovish remarks in two weeks mostly concern the possible reduction of the pace of rate hikes to two from three for the next session. A double rate hike a year ago would have been considered anathema. Today, it is seen as manna.
Meanwhile, everyone on the Federal Open Market Committee is focused on inflation numbers
This is bad news for investors, but also bad for the Fed. The US economy is slipping into a seemingly mild recession.
However, the pace of slowdown could accelerate, as external economic conditions deteriorate, the housing market is clearly suffering, manufacturing is contracting and consumers spend their savings and rack up expensive credit card debt to which a divided congress will be of little help.
Meanwhile, credit conditions continue to deteriorate, and this is becoming felt everywhere, from high-yield markets...
...to investment-grade credit spreads and the ever-deep US Treasury markets.
Adhering strictly to its inflation mandate, the Fed often behaves as if the rate for the world’s global reserve currency exists in a bubble. Failure to acknowledge the external risk build-up increases the probability of a financial accident.
The real risk is not the accident itself, it is the 14 years when all manner of accidents were prevented with the use of money printing may have made markets and policymakers complacent.
We believe that the pivot, orderly (which is our base case) or disorderly (in case of an accident) will come. The question is at what cost to the global economy?
Unfortunately, the Fed is not the only one viewing things parochially. Earlier this month, pundits cheered Jeremy Hunt’s Autumn Statement.
The deferment of some key tax obligations for the period closer to (or after) the general election was seen as a masterstroke to calm markets and at the same time avoid putting too much extra stress on consumption. “We must be very careful not to assign to this deliverance the attributes of a victory,” Sir Winston Churchill might have warned us.
Avoiding a market panic is a very low hurdle to defining a ‘good’ Budget. For one, it does little to alleviate current consumer pains.
Economists see more than 90 per cent probability of a recession for the next year. More importantly, the government failed to convince international investors to return to British risk assets – which they have, by and large, shunned after the referendum.
Meanwhile, the EU sent a warning letter last week that Brexit issues, especially pertaining to the Northern Ireland protocol, remain open, despite the goodwill exhibited by Rishi Sunak’s government.
This comes after the government’s statement that it is not looking for a Swiss-type deal, and will steam ahead towards the deletion of 4,000 EU laws from UK statute books.
The narrative suggests bond vigilantes attacked Kwasi Kwarteng’s expansive Budget. However, as long as external bond market conditions remain precarious, the UK bond market is still in peril.
The very notion of Brexit could find itself at the centre of fresh market turbulence, leaving Sunak’s government with very few options. It has already capitulated to market demands, tightening fiscal policy.
If markets attack Brexit, how could the government for which the notion is a raison d'etre possibly react?
What investors and managers need to do
Our job number one is to acknowledge risks. We have unwaveringly done so and have been keen to share our concerns with clients.
The question is what can portfolio managers and investors do in this environment, especially when diversification has not worked this year?
Seasoned asset managers are planning ahead, keeping market ‘bets’ to a minimum, either by holding cash or by being ‘neutral’ in their asset allocation, which we have been doing since our last September meeting.
Also, we have managed to steer clear of areas where the downside has been significant.
From any exposure to new-age assets such as cryptocurrencies (which seemed to be getting a lot of attention eighteen months ago), to illiquid securities and funds, such as real estate, we have made sure our investment offering is liquid, transparent and of high quality.
Meanwhile, we need to acknowledge upside risks as well as downside risks. Over-protecting a portfolio, or reverting to cash, could risk missing the market rebound, causing lacklustre returns for years to come.
It is exactly because of the higher probability of further financial distress that we believe the pivot could come sooner rather than later. Thus we are making plans to ensure we do not lose out when and if the pivot comes.
The very high level of cash suggests institutional investors are also waiting on the sidelines for precisely an abrupt US policy reversal.
Investment managers should not fail to acknowledge the lack of visibility in a very bad environment. Instead, they should be open about it, and protect what can be protected. Hence, our ‘neutral position’.
George Lagarias is chief economist at Mazars
