This is music to the ears of investors conditioned to position their portfolios to gain from steadfast central bank liquidity support, especially in the US. But with Wall Street having already reflected this in asset prices, and with the benefits for Main Street continuing to disappoint, investors may well need an increasingly differentiated approach if they are to continue to benefit from the “central bank put”.
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Ms Yellen’s key views may be summed up in five points:
• Concern at the human toll of continued sluggish economic growth and persistently high unemployment.
• Faith in the ability of unconventional Fed tools to materially improve the outlook, and to do so without triggering inflation.
• Willingness to underwrite the potential “costs and risks” of relying on this untested policy approach, be they domestic or cross-border.
• Belief that sufficient economic growth will be forthcoming to allow for the eventual orderly normalisation of monetary policy.
• To the extent a policy mistake is forced on the Fed, and every effort will be made to minimise this risk, it is better if it were one of excessive accommodation rather than premature tightening.
Asset markets still key
Based on these five points, Ms Yellen left no doubt that she is committed to maintaining the Fed’s current approach – one that places asset markets front and centre in the transmission mechanism linking Fed actions to policy objectives.
Positioning for the impact of Fed policy rather than fundamentals has been a winning strategy for investors – not only in the immediate aftermath of the 2008 global financial crisis, but also in the past three years during which the Fed has pivoted from normalising markets to pursuing much more ambitious macroeconomic objectives. But they now need to be increasingly mindful of the level of prices and the associated (and growing) number of disconnects that the Fed is underwriting.
This year’s impressive performance of risk assets (including the 21 per cent year-to-date increase in the MSCI world equity index as of Friday, powered in particular by US stocks) contrasts with a global economy still stuck in third gear.
Investors now need to be increasingly mindful of the level of prices and the associated (and growing) number of disconnects that the Fed is underwriting
It has materialised in a non-linear fashion, including a particularly rough patch in May-June when questions surfaced about the willingness of the Fed to continue its exceptional support for markets and the economy. It has involved a notable deviation in performance between advanced and emerging markets. And investors have repeatedly “looked through” harmful US political polarisation and Congressional dysfunction.
In reconciling all this, it would be foolish to ignore the role of the Fed in asset price determination – a role that has been direct, large and persistent; and one that has influenced both investor behaviour and companies’ capital structure operations.
Looking forward, investors would be well advised to remember Ms Yellen’s correct observation that robust growth is the best way to allow for the orderly normalisation of monetary policy. Indeed, it is probably the only way. And, for investors, durably higher growth is what validates the current prices of most risk assets.
Unfortunately, apart from the Fed, it is hard to point to policy making institutions that are seriously engaged on pro-growth initiatives. Instead, most are sidelined by continued Congressional dysfunction.
In such a world, differentiation within and across asset classes becomes much more important: be it emphasising the front end of the government bond yield curve, seeking solid balance sheet companies with real profit prospects, or positioning for the forthcoming disposal of assets by deleveraging European banks.
Greater analysis should also be devoted to the extent to which US equities can continue to outperform so sizably the rest of the world. Yes, Fed policy encourages companies to raise debt and give more cash to equity holders via dividends and share buybacks. But there is a limit to relative valuation deviations in today’s globalised world economy.
Ms Yellen’s message is clear: the forthcoming change at the helm of the Fed signals policy continuity. Yet in positioning for sustained Fed support, investors need to remember that Wall Street cannot – indeed, should not – deviate so much from Main Street.
So, pending stronger evidence that higher global growth will indeed materialise, many investors would be well advised to opt for greater portfolio differentiation.
Mohamed El-Erian is chief executive and co-chief investment officer of Pimco