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

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The first half of 2013 was a startling reminder of how poorly traditional asset allocation diversifies actual investment risk. For most, it proved to be an extremely difficult period to make money using the traditional approach because a single risk factor – interest rates – largely drove returns across asset classes.

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A quick look at the July employment report seems to reinforce the importance of participation rates in the path to the 6.5% unemployment threshold Fed Chairman Bernanke laid out last December. As we’ve speculated, meager gains in employment can have a material impact on the unemployment rate because so many people are leaving the workforce due to demographic changes.

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Those of you who have followed our thoughts about evolving Federal Reserve policy here and here and here will appreciate a forthcoming paper by economists at the Federal Reserve Bank of Chicago which concludes that changing demographics have dramatically lowered the number of jobs it will take to impact the unemployment rate in the future.

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There may be more to unemployment numbers than meets the eye. Conventional wisdom has it that as the economy rebounds and jobs are created, people begin to reenter the labor force, making the unemployment rate a particularly stubborn number on the way down.

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The job of the Federal Reserve is ‘to take away the punch bowl just as the party gets going’ as one Fed Chairman once said. Typically the process has started with a hike in short-term interest rates, a step toward the exit with the punch bowl in hand indicating the economic party was getting raucous.

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As part of what one of our managers described as “a bull market in fear,” 2012 was a year in which central banks around the world ganged up against savers and forced them to choose between monetary debasement and navigating a minefield trying to escape it.

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We believe many of the uncertainties that clouded the horizon in 2012 are slowly being resolved or constructively contained. In fact, we also see domestic economic strength that would indicate an earlier hike in interest rates than is currently priced into the market.

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Investors can often mistake the asset diversity in their portfolios for adequate risk diversification. Author Jason Hsu, of Research Affiliates, argues many investors who are diversified around investment products may be poorly diversified by risks.

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