Policy making will likely drive markets as fiscal and monetary policy align, while in the meantime, investors turn to active currency management as defensive assets and government bonds are not offering expected tail protection.
Bob Prince (main picture), co-chief investment officer at Bridgewater Associates told the Investment Magazine Fiduciary Investors Conference that defending against inflation remained one of the firm’s most important strategies.
“There’s not very much inflation priced in, so that’s the first thing I’d defend against by having a better balance of inflation and deflation assets,” Prince said.
He described the typical portfolio as a barbell, with high-risk assets on one hand and low-risk assets on the other that should diversify.
But since low-risk assets have not been generating much yield, nor much diversification, clients have been asking how they can restructure their entire asset allocation.
“One of the things we’ve done with them is to change the way they think about equities,” Prince says.
“We’ve been deviating away from the Cap M approach, which suggests that investors are rational and profit maximising.”
Instead, governments have begun ‘policy maximising’ which has prompted cash and bonds to become funding vehicles.
“And because this is intentional, we’ve started thinking more intentionally about the cash flow yield of an asset, and the susceptibility to yield changes.”
Rather than just trying to beat the equities benchmark, Prince says a classic bottom up valuation, cash flow yield investing approach in public or private equities will offer protection in a portfolio.
“If you build a portfolio with a high cash flow yield and it’s got a good return to risk ratio, it will still underperform the market for long periods of time,” Prince says.
“That’s part of why value stocks are being dumped, because they’re underperforming the market, but it doesn’t mean they’re not generating a return.”
Prince also suggested adding currency into the defensive mix.
“In this environment, you have big differences in economies, between the East and West, and there’s monetisation going on with very low yields in the United States,” he said.
“So strategic currency mix is another element that might be more balanced, if not defensive.”
As monetary policy has driven market action in the past decade, Prince categorised the monetary policy’s evolution in three stages.
Firstly, there was interest-rate-driven monetary policy which saw rates reach zero. Secondly, quantitative easing stepped in. And ‘monetary policy three’ or MP3, is when monetary policy and fiscal policy coordinate together.
“MP3 works very differently to the other two,” he said.
“In contrast to an interest-rate-driven policy, this means you move interest rates by three to five per cent to change the economics of borrowing and lending, which changes spending, which changes incomes and employment.”
“So the power really transfers to the government, and the fiscal policy, and this is the environment we’re facing now.”
Noah Weisberger, managing director, Institutional Advisory and Solutions at PGIM, agreed that government is now much more involved than previously.
“The incentives for policy coordination, something that we haven’t seen in the US for decades and decades, is definitely present,” he said.
“We also think that loss of Fed independence or the perceptions of lost fed independence, and of coordinated policy, has reinforced some of these changes in the way economic growth and interest rates interact with each other.”
Ultimately, stock and bond correlation are tied to the volatility of interest rates.
“Since the Fed is suppressing rate volatility, and keeping rates low, because they have other objectives, like supporting debt payments, then we could go to a very different world,” Weisberger said.