Wednesday, October 23rd, 2013

Same Old Fed

Given the volatility of the newsflow coming out of the US over the last few weeks, it is remarkable how little the main recommendations of our asset allocation models have changed. Depending on your point of view, this either shows that our models are completely insensitive to the real world, or that they concentrate on the underlying issues even when the headlines are screaming disaster and salvation on alternate days. We naturally incline to the latter view. This should mean that what has changed is actually important.

Change #1: Emerging market equities are starting to perform. This rally does not show up in our sterling or euro asset allocation models because the weak dollar still depresses returns. (We still regard all EM securities as dollar proxies.) However the US dollar model now has EM equities in fifth place (up from eighth in early September) and on the basis of our probability curves we expect it to overtake Japan (currently fourth) in the near future.

Change # 2: Emerging market debt looks as though it has bottomed. Again this is only apparent in the US dollar model, but the weighting has begun to increase, and there is clearly room for US investors to do more. A good investment case can be made purely on the grounds that we are past the crisis of the summer and that volatility is likely to fall. This is an argument about rebalancing in the face of changing risk conditions, not projecting significant excess returns.

These two changes are of course consistent with the view that the Fed under Yellen is likely to be “looser for longer”. This debate is now caught up with the macro-economic impact of the US government shut-down and the data vacuum / distortions arising therefrom.  We think that this misses the point that asset prices are either high (US Equities), very high (US Treasuries), or recovering strongly (US Housing and Commercial Property).

The last two recessions in the US were caused by asset bubbles which were widely-discussed at the time, but which the Fed failed to tackle until too late. They were many other problems besides excess credit creation, and there are many other policies which could have mitigated them, but that is no reason to keep QE at full throttle this time around.

Unemployment is a lagging indicator. The transmission mechanism from loose monetary policy into asset prices has always been faster than into job creation. It may even be getting faster, while transmission from the financial sector to real economy has probably gotten slower. If the Fed continues to base its policy on employment data, there is a greater risk that asset prices will be dangerously overvalued by the time that policy is tightened and that the tightening will have to be more aggressive. The impact on confidence (and therefore job creation) will greater than if the taper had been “sooner and slower”.

We think the greatest threat to US jobs is asset hyper-inflation and excess leverage; the Fed apparently disagrees. This is why our models continue to prefer equities to bonds and want to rekindle the love affair with emerging markets, even though we think the US is on the verge of a serious policy mistake.

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