We seem to live in a world where the markets believe bad news is good news. The worse things get, the more excited markets become about yet another round of stimulus by the Federal Reserve. Whether it’s uncertainty around Greek elections or weak economic data, markets have supreme confidence in the willingness of the Fed to support financial markets during economic weakness. Some people think this is bad – they bemoan a Federal Reserve that is overstepping its role, messing with fundamentals, eroding the value of the dollar while supporting risk takers, etc., while others think it is good – in their minds, the toxic asset purchases, operation twist and so on have saved us from the clutches of the kind of debt deflation and liquidity trap that Japan has been grappling with for more than two decades. Many have trouble making money in this environment. While different in magnitude and scope now (reflecting a far larger, more global and more complex economy), central bank intervention to affect asset prices is as old as the hills. We recognize it is a reality of monetary policy and we believe it underscores the need to be mindful of and diversified around the more fundamental drivers of an economic cycle (e.g. liquidity, volatility, currency, interest rates, credit spreads, growth, and inflation).
To love or hate Fed intervention is beside the point; asset prices are one way monetary policy is transmitted through the economy and it is a reality that central banks consider when controlling for inflation, deflation and attempting to impact growth (economist Irving Fisher suggested more than 100 years ago that central banks need to consider asset prices when setting monetary policy; Fed Chairman Alan Greenspan spoke nearly 90 years later to the importance asset prices have in setting monetary policy).
While it may appear like a pacifier for a colicky baby, there are a few good reasons a central bank might directly or indirectly target asset prices: it improves expectations and confidence which, in turn, stimulates demand; it supports asset prices, making individuals feel wealthier which, in turn, stimulates demand; and it supports the value of collateral which banks use as a basis for extending credit which, you guessed it, ultimately stimulates demand. In an oversimplified way, it’s all designed to create an illusion of stability and prosperity so that real stability and prosperity can take hold. That’s what central banks do – they act as lenders and liquidity providers of last resort during bad periods until a more ‘real’ and lasting economic growth is restored; they take away the proverbial punch bowl when that growth gets going again.
Portfolio diversification strategies that target only asset classes at a time in the economic cycle when the Fed wants all asset classes to do roughly the same thing (create the illusion of stability and prosperity), leave the investor woefully under-diversified (and heavily exposed to equity risk). Strategies that prosper during periods like this exploit the volatility the good news / bad news environment creates. Strategies that prosper during periods like this exploit the market’s insatiable hunger for liquidity and safety by stepping ever so slightly out the liquidity spectrum and being ratings agnostic. Strategies that prosper during periods like this take advantage of the fact that traditional credit providers have new regulatory and capital constraints and may be unable to lend to healthy and growing, but capital-constrained individuals and businesses. Our point is that it is far more constructive to be diversified around the core drivers of the economic cycle than to remain anchored in asset classes, bemoaning Fed intervention and the correlation conundrum it creates.
Bad news is still bad news. The fact that the market is buying into the illusion is exactly what creates opportunities in a well-diversified portfolio.