Investing in a low-volatility world
Over the last five years, there’s been a lot of healing. Some of the extreme volatility we experienced has subsided, and we’re seeing a return to some risk taking on the part of shareholders. Overall, I am modestly “risk on” in the funds I manage.
The main drivers of that optimism for risk assets are sustained economic growth in the U.S. and central bank policy. Central banks around the world have thrown a volatility blanket over the markets. I think people in the past have underestimated the power of central banks. As long as the economy remains in expansion mode and the central banks continue to push as hard as they have been, I don’t see the market falling significantly in the near term.
So that begs the question, what is the endgame for quantitative easing? Personally, I wouldn't be surprised if the size of the Fed’s balance sheet remains inflated above historical norms for a really long time. Consequently, I don’t see an end to the Fed’s quantitative easing any time soon. However, we could see an adjustment in the pace of QE purchases. In fact, the Federal Reserve opened the door to a more flexible policy with its May statement. It’s my opinion that economic conditions still appear far removed from the sustainable gains the Fed has targeted in order to change tack. Nonetheless, with more uncertain monetary policy, volatility has been on the upswing.
With the specter of increasing volatility, investors need to be sure that they know what they own and that their managers are being disciplined in what they’re buying. There’s a lot of incentive right now to reach for return, especially yield. But investors who do that now, while volatility is still relatively low, might be unpleasantly surprised at how their portfolio performs when volatility spikes.
Favoring yield, but no options are cheap
I don’t see any income-producing asset classes that I would consider inexpensive. Income in general is fairly valued to expensive as a result of central bank policy and demographic forces, particularly the retirement of the baby boomers. So we have to choose income assets that give us the best value on a relative basis.
I think today’s environment argues for the prudent use of higher-yielding options. While the prices for all kinds of bonds are elevated, the macro climate looks constructive. Economic growth is shallow but stable, corporations have strong balance sheets and good earnings—they can afford their debt—and tail risk is muted. So while I don’t think we’ll see a lot of price appreciation, I don’t think we’ll see significant depreciation either. Or if we do see a downdraft, it could be short lived. If that is the case, returns are likely to come from income, so I’m favoring bond assets that pay relatively higher yields.
For example, I’m overweight in high-yield bonds versus Treasuries. High yield pays an average coupon of 7.50%, and I don’t see anything like that anywhere else. Likewise, emerging-market debt is a more modest overweight as the market has recently consolidated.
Caution on preferred stock and commodities
While I favor yield right now, I don’t buy it blindly. For example, preferred stock has been paying a yield of about 5%, on average. But about one-third of preferred stocks are past their call date, and the market is priced at a premium. So if your preferreds are called, you might get a price lower than you paid—and that loss will eat up a lot of the income you gain from them.
I'm also underweight in commodities, because they pay no income and I think the supercycle for them may have turned. In the past 10 years, we’ve seen commodities run wild, driven by emerging markets like China. But as these economies move toward a consumer-driven model, I don’t expect they are going to buy commodities at the same high rate, so the demand side should cool. On the supply side, the shale revolution in North America is easing prices in the energy sector. Owning commodities as a hedge against inflation may still make sense, but I don’t think they’re a good tactical play right now.