Technology has been a meaningful driver of the current dynamic between inflation and the bond market. The internet, in particular, is changing the way economic health should be measured and, accordingly, the way investors position themselves.
Our classic monetary metrics are doing a poor job of evaluating the health of the economy, as the digital economy is very hard to measure in monetary terms. Technology has created significant increases in utility absent any real inflationary uptick. In fact, it can be argued that much of the technological development to date — and even on the horizon — is deflationary. This is likely to continue as the next big wave of innovation, the blockchain, strives to eliminate middlemen in many areas of the economy. This mismatch between the metrics and what is really going on in the economy could be causing central bankers to keep their feet on the gas longer than needed.
Technological innovation might cause inflation expectations to be permanently lower. Further, advancements in technology might mean traditional measurements of economic health also need to advance and evolve, particularly monetary aggregates. Modern economic theory is based on the idea that money is the ultimate measure of economic activity. Compensation, trade, commerce and investments are all measured in monetary terms. What if one could create a store of wealth that is different from money, as is occurring with cryptocurrencies? Initially our economies were based on bartering, then we used tokens resembling coins, later gold and then paper currency backed by gold. Then, in 1971, we finished the process of unlinking our paper currency to gold. For decades we have accepted the value of simply paper currency. Why couldn't data encryption also become a store of value? After all, if enough people agree that data encryption has value as a medium of exchange (not unlike paper currency) then it becomes a currency. The challenge for central bankers is that their classic economic tools are unlikely to measure this potentially momentous change until it is very far along in the process of adoption. Therefore, the current policy prescription of low interest rates may be misdirected.
It is unlikely that the central bankers of today, most of whom are classically trained economists, will publicly lead a change in thinking. But they do appear to be concerned with the asset price "bubble" and might choose to allow real interest rates to rise without seeing the classic measures of inflation rise. Comments from November's Federal Open Market Committee meeting indicate that although labor markets continue to strengthen and economic activity appears solid, inflation remains contained at less than 2%. The FOMC Statement noted near-term risks to the economic outlook appear "roughly balanced" but that the committee expects that gradual increases in the fed funds rate are likely.
There will always be value to be found in the markets but, thanks to years of easy liquidity, most credit and equity instruments are now rich by historical measures. Investors need to be scrupulous to find opportunities that can perform well while withstanding a potential period of stress brought about by an eventual change in risk perception. Investors would be wise to consider a number of factors and ideas:
- Focused stock picking and credit selection should — in the intermediate term — do much better than the broad indexes whose performance is agnostic to fundamental valuation.
- Historical cross asset correlations might have changed, and equity and bond performance so far in 2017 represents to many a conundrum. Further, the U.S. dollar reflects that the U.S., once the model of stability given the steadfastness of our leadership, is now a source of global instability. We should prepare for a prolonged period of dollar weakness despite the actions of the Federal Reserve. If this is the case, many of the quantitative macro models that rely on consistency in cross asset class behavior could be challenged. Also relative value strategies that trade across asset classes will be more difficult to assess, and focus should thus be on those within asset classes.
- We are on the doorstep of a reduction in the Fed's balance sheet and the European Central Bank is starting to reduce its quantitative easing activity (although any moves likely will be measured and well telegraphed). Acknowledgment by central banks that new forces in the economy are dampening inflation readings might lead to the realization that higher yields are necessary to inject a dose of reality about risk into the markets. With the end to QE unfolding, the liquidity tailwind could quickly become a headwind for asset prices, putting pressure on equity and credit prices (particularly investments yield-chasers have flocked to despite weak underlying fundamentals).
- Index strategies are concerning in that they are agnostic to valuation. The more overpriced an asset becomes, the bigger its share of the index, and the more the investment strategy that follows the index must own of the overvalued asset. Such a pattern can easily reverse itself if active investors decide to sell overvalued assets en masse. Therefore, passive index strategies might be hard to beat in good times but active management is likely to prevail when the cycle moderates or turns.
- Finally, exchange-traded funds have given apparent liquidity to a sector of the market in which the underlying assets are not that liquid. Of particular concern are credit ETFs that focus on high-yield bonds and loans. Should the economy cycle downward, and investors decide to shed credit risk, the selling of these ETFs will quickly test the limited liquidity of the corporate bond market.
The time is ripe to shift portfolios to become more "all-weather" and to balance risk. For the months ahead, we believe a neutral weighting (at best) is appropriate for credit strategies with a beta tilt and equity strategies with a lot of beta. We are becoming a wealthier society given our increased technological utility but one with low inflation due to the Amazon, iPad and, potentially, blockchain effects.
The transition from the classic approach to monetary policy to a more "new age" approach will clearly take time. Most of our central bankers are well-versed in classic economic theory and might be resistant to changing their traditional approaches. Furthermore, the outgoing Fed governors are unlikely to make any near term changes leaving measurement of "iPad iNflation" to a new Fed leadership. Technology will continue to change the inflation and utility outlook. Monetary policy must soon adapt to this "internet of stocks and bonds" or risk stoking greater asset bubbles to deal with in the future.
Basil Williams is managing director and head of portfolio management at Pacific Alternative Asset Management Co. LLC, Irvine, Calif. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.