Rick Rieder and Russ Brownback argue that an evolving policy stance at the Fed is altering the risk/reward calculus for investors this year, although left-tail risks remain.
Over recent weeks, the Federal Reserve has made a virtuous policy pivot in response to slowing global growth, decelerating U.S. inflation, and acute financial market volatility. Specifically, Chair Powell, Vice Chair Clarida, and several other Fed governors have all come out to highlight the need for patience and flexibility in adjusting monetary policy in 2019, a policy approach that has dramatically altered the way we’re approaching portfolio construction. With the Fed now pursuing a more balanced approach that acknowledges divergent macro influences, we are emboldened to be more proactively positioned in select risky assets that now offer demonstrable intrinsic value on the heels of 2018’s broad-based bear market for risk. Of critical importance to this approach is that owning risk-free U.S. Treasuries now provides both an attractive real yield, as well as a reliable hedge to risk today. In essence, in 2018 few assets worked for investors, other than cash, but as we enter 2019 both the policy and market landscape now allow for building balanced portfolios again, with attainable return targets.
Policy evolution alters the investment landscape
Considering that the effects of policy tightening are manifested with a lag and that global growth is decelerating, U.S. fiscal stimulus is set to wane, and U.S. inflation remains stubbornly below the Fed’s desired target, our comfort in owning U.S. Treasuries in a balanced portfolio is bolstered today. Understanding this mix of influences, we expect the Fed will eventually slow and ultimately cease the runoff of its balance sheet in addition to halting further rate hikes. We think this balance sheet reduction is the primary catalyst in driving global liquidity growth to its slowest post-crisis level, which in our mind represents the greatest left-tail risk to an otherwise moderate and manageable descent toward economic soft landing.
Between the lines of the Fed’s mandate is the need to keep borrowing costs for consumers and enterprises in-line with potential growth. If rates are too low, credit bubbles can form, but if rates are too high constrained credit can weigh on activity (see graph). Today, we see market-based borrowing rates as appropriately priced to balance this mandate, meaning we like being a lender to high-quality investment-grade (IG) corporates and emerging market (EM) debt today on an all-in yield basis, with some exposure to high yield debt as well. While growth is undoubtedly decelerating, we judge many IG and EM balance sheets to be quite strong through the lens of leverage, liquidity, and cash flow.
Higher wages weigh on margins, don’t lead to inflation
As we have argued elsewhere, many market prognosticators have pointed to accelerating wage growth as sufficient motivation for policy makers to place the brakes on the economy with more hikes in 2019; we disagree. There is no positive statistical correlation between wage growth and inflation and in fact the opposite is true. Wages follow inflation, not the other way around, and inflation today is irrefutably decelerating. Instead, policy makers should embrace the fact that wages are growing fastest for the lowest income households for the first time in a generation, a phenomenon that should be fostered and encouraged, not curtailed.