The Federal Reserve has indicated that next month it will finally wind down its historic and quite debated asset purchase program (referred to as quantitative easing, or “QE”). There are many opinions as to the efficacy of the program both shorter as well as longer term.
Only time will tell what the actual effects of the program will be. This program has been but one tool that the Fed has ginned up to deal with the crippling effects of the financial crisis. Together, they have allowed for the U.S. to rise out of the Great Recession with five straight years of low but consistent growth of GDP, employment and, yes, asset prices.
Now that the program is drawing to a close, many folks wonder what effect it will have on the economy and asset prices. The argument is that the cessation of QE liquidity injections into the monetary system will act as a “tightening” of credit and liquidity. We certainly agree that stopping QE will stop one channel of monetary stimulus, but overall, the Fed remains very easy on monetary policy and will likely remain that way for a significant period into the future.
I long believed that investors should never “fight the Fed,” as the saying goes. It's a lesson I was taught early in life and one that I fully subscribe to as one of the few “absolute” rules to live by in the financial markets. The Fed has shown us the value of this lesson over and over and the most recent creation of financial tools, such as QE, emboldens our belief even further. The term “never fight the Fed” means that you should position your asset allocation to benefit from where the Fed is pushing the economy.
To quote hockey star Wayne Gretzky, “a good hockey player plays where the puck is. A great hockey player plays where the puck is going.” What has become the credo of an aspiring great investor is to play your asset allocation to where the Fed is going.
NO SIGN OF TIGHTENING
The argument that the Fed's ending of QE is a sign of tightening is just not true. The fact of the matter is that QE is a program that was never used before by the Fed. Normally, monetary policy is set with a combination of short-term interest rate adjustments as well as reserve requirement and other more traditional credit and borrowing oversight. QE was implemented as an extraordinary response to an extraordinary credit and banking crisis. Now that the crisis has passed, the Fed is simply removing the extraordinary program. What remains, however, is a Fed that is still very committed to easy monetary policy and shows no signs of changing that any time soon.
The Fed has stated that in order to achieve their dual mandate of stable prices and full employment, they have set goals of 2% inflation and somewhere around the 5% to 5.5% unemployment rate. Further, they have stated numerous times that they will entertain inflation in excess of 2% in order to gain progress in employment. Publicly, they are advocates of higher inflation expectations in the face of global deflationary pressure. That's “where the puck is going.”
Our playbook, given this direction of the Fed, has been to overweight risk assets and underweight quality/safety. In times of mild inflationary pressure, as the Fed anticipates, earnings and equities do well and debt suffers. Credit risk is more favorable than duration risk in fixed-income assets. After saying this, we have seen neither any consistent inflation pressures materializing nor consistent low interest rates. Our suggestion is to not be lulled into a sense that the Fed failed. Remember, the Fed's tools are infinite and they have the will and ability to pursue their “zero interest rate policy” as long as they desire. That means that being long risk and short safety might be the correct trade for quite some time to come. Using historic cycles to extrapolate future cycles is common. What is uncommon is the current cycle. It is the result of extraordinary stimulus.
If the economy shifts gears and begins to grow at a much greater pace, the Fed will most likely leave the “punchbowl” out longer rather than shorter. We hold this position simply because Chairman Janet Yellen has publicly stated this position on many occasions. A stronger economy is what the Fed is looking for, but the durability of the strength is a huge concern of hers.
In fact, what we see globally are central banks copying the actions of the Fed. Global monetary policy is as easy as at any point in history. Because we live in a global economy, investors should take note of global opportunities. Thus, if you believe that global economies will react similarly to monetary stimulus as the United States, then asset allocations should reflect “where the growth puck is going.” We believe that there are timely opportunities in Europe and emerging markets that can highly reward investors as growth stimulus takes hold there. Many of these economies have recoveries that are behind the U.S. but they are catching up. Current valuations suggest there is opportunity globally as well as further opportunity domestically.
Paying heed to an investment discipline that does not fight the Fed has been a long-term winner for investors. The Fed, as well as global central banks, continues to maintain very easy monetary policy designed to generate economic expansion, raise inflation expectations and decrease unemployment. As the world sees the progress in the United States they have begun to emulate the Fed, and we believe that will be good for both U.S. asset prices, but especially good for European and emerging market equities.
Scott Colyer is chief executive officer and chief investment officer of Advisors Asset Management