As the data tells us today, interest rate risk has bled across asset classes in a way that resembles how credit began to dominate asset prices in 2007. The biggest difference is that this time it is the intentional effect of monetary policy, whereas the credit bubble was a much more indirect and unintended consequence of monetary policy. The core purpose behind quantitative easing is to stoke investment by driving investors out of ‘safer’ government bonds into assets with similar characteristics, such as credit risk and duration. This has driven investors to buy corporate debt, high yielding equities, and so on. These are all forms of direct investments that translate into real GDP growth, but they’re also all investments that are driven by declining yields elsewhere. That is the economic lever by which the Federal Reserve has ‘infused’ asset prices with interest rare risk in a way that is very different from previous interest rate cycles.
The risk elephant in the room is interest rates. A traditional analytic approach would likely miss this fact, obscure it or confuse the dark foreshadowing as a buying opportunity. Information days have provided us with valuable insight into how ostensibly different assets are tethered together by an interest rate leash right now. The integration is an intentional element of quantitative easing and will likely have devastating consequences for portfolios that are not deliberately built with underlying risk factor diversification in mind when the Fed changes course.
Rain portfolios have been resilient during turbulent markets this year in large part by missing the interest-rate-related potholes that have come along. During the third quarter in particular, Rain portfolios continued to benefit strongly from the tilt toward high quality, developed-country equities and away from assets that we view as particularly sensitive to interest rate volatility, namely most fixed income sectors, commodities, emerging markets (equities and debt), and inflation related assets, like TIPs. Our defensive posture toward interest rate volatility does also have implications for the growth side of portfolios; we are increasingly cautious in core growth strategies for the mere reason that equity markets cannot entirely escape interest rate volatility either. At the most basic level, the discount rates that factor into equity valuation models are directly tied to prevailing interest rates. Interest rate volatility therefore impacts perceptions of the value of companies’ future cash flows which will likely translate into a rougher ride in equity markets as rates normalize. In Rain portfolios, we will be placing greater emphasis on low correlation growth strategies.
This is an excerpt from our article “Information Days: What scatters, what sticks together, and why?” published October, 2013.