The most important change in Fed Policy four decades
In his press conference during March, Chairman Powell emphasized that monetary stimulus will remain until the labor market has achieved maximum employment and inflation is above their 2% target, for some period of time. Since Volcker broke the back of runaway inflation in the early 80’s by raising rates to 20%, the Fed has engaged in pre-emptive rate hikes based on their economic forecasts. Put simply, the Fed “pulled the punch bowl” before inflation could get out of control by raising rates.
No more! The Fed will let inflation run hot, perhaps to 3% or 4% as they believe that structural dis-inflationary headwinds will keep average inflation low over time. Currently, they believe this means they will keep Fed Funds at 0% for another 2 years until 2023.
It’s hard to overstate how revolutionary this is. The Fed has been worried about inflation for decades. Meanwhile, as it turns out they were wrong all along – structural impediments to inflation were all around us, yet the Fed raised rates at every turn to battle a demon that never existed, after the fact. All of their forecasts were wrong. Now, as inflation seems to be on the rise, and rates are close to zero, they tell us that they are no longer worried about inflation and they are comfortable with letting the economy run hot even if inflation gets above 2%.
Can you see the irony in this? They have tacitly acknowledged that their forecasts and policies have been wrong for decades and that inflation never was a problem after the fact, but they have it right now. Do you believe them? We are wary at best and suspicious at worst.
Our view is that this newfound extreme in monetary stimulation will likely have a positive effect on the markets in the near term but in the long term we are concerned this could backfire. With the Fed this stimulative and the economy reopening, it’s hard to see the market not do better in the near term. But in the long term, this new policy is highly risky, especially with the heady valuations we have right now. At some point the risk is the economy overheats, the Fed is forced to raise rates more than the wish, and then we have a problem.
But that is a problem down the road in a few years. It seems in the near term the punch bowl will stay at the party. And outside of a geopolitical event we can’t see, the near term future seems positive for equities.
But what to do with bonds?
The economic picture is very bright: the Fed is supplying abundant liquidity as the economy seems to be re-opening – post Covid. As such, yields have moved markedly higher over the last 6 months. Total returns on bonds have been negative – anywhere from -15% on Long Term Treasuries to -3% on the broader bond market that includes all bonds (both Treasuries and Corporates) with a more moderate duration.
We have kept our duration very short and have mostly sidestepped the negative effect higher rates have had on bond portfolios. Our guess is that the bulk of the rate rise is behind us, but there is still a chance that they could drift higher in the coming months. If we get the proper technical and fundamental signs that rates may have peaked and may head lower, we will extend our duration, but right now we are taking a conservative posture in bonds.
The market has moved higher so far this year with the S&P 500 up +X% for 1Q. Higher yields are powering small caps, cyclicals, and value stocks to outperform in this market, while “long duration” growth and tech stocks whose earnings streams are more heavily discounted by rising rates have been underperformers. For the first time in several years, we now have a 15% allocation to mid and small caps. Our stocks have a slight value bias so they are doing well. We have also been adding to our ETF portfolio by investing in the themes that we believe will do well in the coming months, and this has worked to our favor: Leisure, Energy, Financials have all done much better than the broader markets.
Our Long/Short process and Volatility manager both did very well last year, and we believe that if there is a surprise to the downside sometime this year, having these strategies in places will provide the risk mitigation we seek. We are currently evaluating other managers that we can diversify into that have good risk mitigation properties in a down market without giving up too much upside in an up market. This is not an easy task, but we are always evaluating different strategies, and will add them if we find value.
Fixed Income Strategy
Our view is that there is at least a 50/50 chance that inflation and interest rates move higher, so we are keeping our bond portfolio defensive in terms of average maturity. Longer term bonds get hurt in such an environment, and keeping a defensive duration is the best strategy. We also believe that there is a reasonable chance that our alternative bond strategy will do well in such an environment. The managers we selected have a good track record in a rising rate environment, and they have performed well over the last few months as interest rates have firmed.