By Mohamed El-Erian, Financial Times
The Federal Reserve remains the best friend of many investors. It is among several key western central banks that are supporting asset prices not as an end in itself but as a means to promote growth and jobs.
In the midst of the global financial crisis, the Fed aggressively injected emergency liquidity and intervened to fix disrupted and malfunctioning markets. In the process, it rescued investors from what would have been irrecoverable losses.
Essentially, the Fed is inserting a sizeable policy wedge between market values and underlying fundamentals. And investors in virtually every market segment – including bonds, commodities, equities, foreign exchange and volatility – have benefited handsomely. In the process, many asset prices have been taken close to what would normally be regarded as bubble territory, with some already there.On several other occasions, the Fed acted to counter the disruptive “left tail” of deflation and recession. Market valuations responded favourably as the institution successfully offset both internal and external risks.
Now the Fed is attempting to meet a more ambitious objective: to deliver better economic outcomes, defined as more robust growth, lower unemployment, and stable low inflation. And last week’s release of the minutes of the last policy meeting leaves little doubt: the Fed intends to keep its foot on the policy accelerator well into an economic recovery.
Central bank action, both real and perceived, rules the investment day, and will continue to do so for now. This is also the case in Europe.
Judging from last week’s policy announcements, the European Central Bank will not hesitate to buy unlimited government securities provided the targeted countries apply for help and deliver on the policy front. It is committed to countering unwarranted risk premia related to currency convertibility risk and financial market fragmentation. Even though it is yet to be made operational, this has already translated into a major boost to investors in most European assets; and it will continue to do so if governments also come through.
Yet with the recent surge in markets, investors would be well advised to remember some basic truths as they continue to position their portfolios (and scale their risk exposures) on the basis of unusual central bank activity:
• The assets likely to be impacted the most and longest are those under the immediate influence of central bank measures – namely the securities they buy directly.
• The more investors venture beyond these assets (and the larger and more illiquid their risk positions), the greater their conviction that unconventional central bank policies will eventually succeed in engineering more robust economic and financial fundamentals.
• It is hard to pin such conviction on detailed analytics or historical experience.Central banks are neck deep in extreme policy experimentation mode, and getting inadequate support from other government entities.
• The longer this persists, the higher the risk that policy benefits will be offset by collateral damage and unintended consequences; and the greater the political heat on central banks.
• If the critical hand-off to fundamentals does not materialise, the reaction of markets will not be pleasant. Positioning on the basis of the “central banks’ put” is a particularly crowded trade. Also, it involves some investors being overconfident in the powerful omnipresence of these institutions, some believing in immaculate economic recoveries, and some feeling they can wait for markets to peak decisively and then exit smoothly.
The summary takeaways for investors are quite straightforward, and important for both generating returns and managing risk.
Investors should definitely pay attention to western central banks and respect the market influence of unconventional policies. But they should do so while keeping a wary eye on how far, and for how long, valuations can be divorced from fundamentals.
Risk exposures should evolve accordingly. Differentiation, both within and between asset classes, should increasingly underpin portfolio construction – with emphasis on companies and countries with both strong balance sheets and positive cash flow. And this need not crowd out exposures to other parts of the world, particularly emerging economies (such as Brazil, Indonesia and Mexico) where central banks are less active but markets are better supported by solid economic and financial fundamentals.
Finally, investors should take with a pinch of salt the operational feasibility of maintaining a maximum “risk-on” position until the markets turn, then making a quick exit. It is an idea that risks sounding better in theory than it works in practice.
Mohamed El-Erian is chief executive and co-chief investment officer of Pimco