Higher Rates, Sure—But Not That High

August 14, 2014

As investors prepare for rising borrowing rates, many seem to be asking all the wrong questions.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features John Forlines III, chairman and chief investment officer of Long Island, N.Y.-based JAForlines Global.

Alexander Bickel, Yale law professor and Supreme Court critic, once commented: “No answer is what the wrong question begets.”

The wooly thinking that Bickel despised is on plain display these days in financial markets, with too many folks asking wrong-headed questions like, “When is the Fed going to raise rates?” and “Are the markets—equity or fixed income, pick one—overvalued?”

Forget those. We think there’s only one relevant question: “Why are the expected rate increases so low?”

The media-driven narrative about the timing of rate increases and the endless prattle on CAPE-Shiller valuations has obscured one of the most important features of post-2008 markets; namely, that the eventual increase in rates by the Federal Reserve in response to the economic recovery will likely be less than any time since the Great Depression.

Why? Because the Great Recession was severe and folks are forgetting that. They’re getting too fancy for their own good with expectations that the reversion to the mean could be swift and sizable.

It won’t be, and the bottom line is this: In some ways, indexing the core of a portfolio in accordance with your risk appetite is as sensible as it’s ever been. Don’t get too fancy with strategic allocations.

But as investors look for the best tactical overlay to help cushion portfolio volatility, they better be thinking clearly and taking true measure of what a credit-driven downturn can do to the macroeconomy in terms of damage and how long the healing can take.

Don’t expect recent history to repeat.

Disconnected From The New Reality

The problem is that many investment models, research and commentary are all stuck somewhere in the late 1990s.

Back then, the main story about the business cycle was based on the classic response to inflation expectations, and the market’s narrative was based on price expectations—as in expected returns over the next few years based on current valuations.

The real story—the one that adequately describes the macroeconomic situations in the U.S., Japan and the eurozone since the ’90s—is about interest rate and liquidity expectations, not price or inflation expectations.

Right now, this right-minded way of thinking is telling us that, almost eight years after the easing began and when the Federal Reserve’s tightening cycle comes to a conclusion, rates won’t look at all as they have in the past several decades.

In other words, rates will not come close to the 2.5 to 4 percent peak in the Fed Funds rate that has generally accompanied the end of a classic business cycle and inflationary pressures historically associated with the end of a bull market.

FOMC_Expectations

Sources: FOMC, JFG


Risks More Global Than Ever

That said, there’s no question the timing of rate increases is important.

The weight of the world is on the Fed to get this part right. If the dollar gently appreciates against the euro and the yen as a result of slow-but-steady rate increases, and this action doesn’t kill U.S. corporate profits, the EU and Japan will have more time to heal and follow the U.S. lead established through quantitative easing.

On the other hand, rate hikes that are executed too fast or go too far will plunge the developed world into disinflation and risk a revisit of the types of capital market dislocations of 2008-2009.

The EU is teetering on the edge as it is, as the chart below suggests.

Eurozone_CPI

But there’s hope:

  • First, global corporations are far more nimble than governments, particularly in the U.S., which is paralyzed by congressional polarization and hasn’t had an official budget or significant tax legislation since 2009.
  • Second, buying time while banks and corporations heal is a tried-and-true formula that the EU must emulate or risk Japan-type deflation.
  • Third, the world is still rebalancing its mix of manufacturing and service-oriented industries, and investment in jobs and retraining will slowly take effect to battle structural unemployment in the developed world.

Credit Matters

To repeat what we touched on above, credit and liquidity factors—as in money supply, which have been important and predictive since the 1940s—are moving to center stage.

Meanwhile, price and inflation metrics will stay erratic—possibly for years to come.

Investment models depending on price metrics like sector rotation, momentum and long/short styles are being forced to recalculate. And that’s the price of asking the wrong question.


JAForlines Global (JFG) provides investment advisory services to clients of broker dealers, their registered representatives and independent RIAs. JFG specializes in constructing actively indexed portfolios using ETFs, which are available for private wealth management investment or in qualified retirement plans via a Collective Investment Trust (CIT). Contact the firm or visit their website below at 516-609-3370 or [email protected] or www.jaforlines.com.


 

 

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