“You let everybody know, but don’t play with me, 'cause you’re playing with fire,” sang the Rolling Stones. Fed Chair Jerome Powell and other central bankers around the world appear to be singing the same tune. Translated, it means “low rates, long time.”
Letting Everybody Know
Global bond yields are reaching new lows, in some cases crashing through zero. This reflects a realization on the market's part that rates probably won't rise anytime soon. Why that's the case is a longer story.
Last year, I wrote in my troop of gorillas series that central banks had ceded some control of monetary policy to the markets, and market activity would govern the speed with which central banks raise rates, reduce their balance sheets, and move away from quantitative easing.
As we exited 2018, I was surprised by the aggressive and coordinated nature of central bank behavior. Powell's speech at the end of December was followed by days of consistent communication from Federal Open Market Committee (FOMC) members and board governors with respect to monetary policy. They didn't have to lower rates because the market did it for them. In other words, “You let everybody know.”
Now, facing signs of slowing economic growth and concerns about trade based on the Trump administration's policies, we have seen another coordinated response from central bankers. But this time it's a global effort. Powell was joined by Mario Draghi from the European Central Bank, Mark Carney from the Bank of England, and others in communicating the same message: we're keeping rates low, and “don’t play with me, 'cause you're playing with fire.”
How Low, How Long?
We monitor implied rate expectations from the price of derivatives and other fixed income instruments—we've observed expectations of short-term interest rates dropping even more than they did in November, December, and early January. The expected effective federal funds rate, for example, has dropped by about half a percentage point.
Given a bit of fear that is creeping into the markets about what will happen over the coming quarters, it's likely that we will see more coordinated communications along these lines come from central bankers. Those communications may not drive rate expectations much lower, but will probably keep rate expectations from rising.
In that environment, the markets have assumed—correctly in our opinion—that rates probably aren't going up any time soon. Inflation's not rising, and real rates can be kept low for a relatively long period of time when the “800-pound gorillas” are the marginal investors.
We believe rates could be low probably for a long time, perhaps even 10 to 20 years.
Getting Ahead of the Fed?
It's hard to get in front of such a coordinated, aggressive monetary policy effort. Sometimes the best strategy is to survive.
We've brought down our assumed yield levels around the developed world, and now have a marked underweight to fixed income exposure and, in our most flexible portfolio, a small short bond position.
In the short term, that's driving a bit of a wedge between our performance and the performance of some competitors who are long bonds, either due to active bets or the fact that their strategies are more 60/40-like in their orientation.
This won't, however, be the case forever. Right now, these types of investors are on a fun ride on the steep drop of a roller coaster. Yields are coming down and everybody's screaming and holding their hands in the air. But there will be a point in time when that same roller coaster has to navigate some twists and turns, some loop-the-loops, some corkscrews, and, eventually, climb back up the hill. In those environments, we believe we are in a great position to exceed the performance that will be delivered by these competitors.
That could happen gradually. I mentioned rates could be low for 10 to 20 years, but, importantly, over that period the current situation will be unwinding, creating a pronounced tailwind for fundamental investors.
Why We Remain Steady
One option available to investors on how to adapt to an environment that hasn't been friendly to their style of investing is to change their philosophical “stripes.” In essence, they would be admitting, “Our philosophy doesn't work. Let's adopt a different philosophy.” For us, that might look something like, “Let's become quant investors and follow some of the factors that are performing well.”
However, we will never do that—not only because it would violate our foundational approach to investing, but because it's also a surefire way to lose longtime clients. We are going to stay with and continue to embrace our fundamental value-oriented philosophy. It's what we know how to do; it's our bread and butter. And it's what we believe will best serve our clients over time.
We invest with an eye on fundamental value even when fundamentals are not being consistently rewarded because of central banks aggressively pushing rates lower like they are now. But, again, we think that as central banks unwind their easy monetary policies, there will be a tailwind for fundamental investors like us.
Also, one area that isn't troubling fundamental investors is the active currency arena. Fundamental value continues to exert its gravitational-like pull on currency prices in a fairly consistent manner. That makes active currency management more effective in this type of environment. Currencies are also typically uncorrelated with equity and fixed income markets. As a result, currencies remain, for us, a powerful tool.
Brian Singer, CFA
Partner & Portfolio Manager
William Blair Investment Management
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