Market veterans say humble pie could become a regular menu item over the next few years.
After the liquidity-driven rally of recent years, the move now to begin tightening the taps should make episodes like the one in May and June — replete with spikes in volatility and markets becoming “very correlated” — more frequent, said Keiko Kondo, a Hong Kong-based senior portfolio manager on UBS Global Asset Management's asset allocation and currency team.
Some analysts call further broad sell-offs inevitable.
The across-the-board drop in risk assets prompted by Mr. Bernanke's comments isn't an anomaly — it's a necessary bookend to the Fed's success at levitating risk assets across the board by artificially suppressing cash rates, argued Mr. Inker.
“Today's valuations only make sense in light of low expected cash rates,” and if that expectation is removed, “pretty much every asset across the board is vulnerable to a fall in price,” Mr. Inker wrote in the firm's quarterly client letter.
Mr. Inker said GMO terms the fairly unique situation facing U.S. and global markets now “valuation risk.”
The only safe haven in this environment is cash, but absent knowledge of when volatility will spike, the opportunity cost of holding cash is too great to do more than settle for making larger allocations to short-duration assets than one normally would, he wrote.
Investors need to position themselves “as close to the exit door as you can ... putting a foot in the door so it doesn't slam shut on you,” agreed Deutsche's Mr. Siniakov.
The sell-off that began May 22 was effectively the first act of a long-anticipated transition — to a sustained economic rebound from unprecedented liquidity life support for the economy by U.S. monetary authorities.
The $53.2 billion Massachusetts Pension Reserves Investment Management board has been focusing for a while on the inevitable fallout from a diminishing Fed stimulus, noted Michael Trotsky, Boston-based PRIM's executive director and CIO, in a recent telephone interview.
PRIM's agenda includes plans to analyze “what we hope our fixed-income portfolio will do for us,” said Mr. Trotsky, adding the state fund's investment team will look to make “incremental changes” over the next six to 12 months.
He declined to provide specific examples.
For May and June, PRIM's allocations to U.S. large-cap stocks, U.S. cyclical stocks and U.S. small- and midcap stocks were the only segments of its portfolio that managed to post gains. Other risk assets gave back some of their sizable gains in the first 10 months of PRIM's fiscal year through June 30, including global real estate investment trusts, off 9.8% after gaining 25.7%; emerging market equities, down 8.6% after climbing 15.3%; and high-yield bonds, which slipped 3.2% after advancing 13.6%.
Even so, PRIM finished the year with a strong 12.73% gain, Mr. Trotsky said, noting PRIM's diversified portfolio contributed to its resilience, and can be expected to continue to do so.
For many market veterans, the argument that the risk asset sell-off of May and June suggests diversification has lost its charms doesn't hold water.
“Correlation is only meaningful if measured over reasonable periods” of years — not a month, noted Peter Ryan-Kane, the Hong Kong-based head of portfolio advisory, Asia Pacific, with Towers Watson Investments.
If the time period is extended from May 22 to July 31, some segments such as U.S. Treasuries and emerging markets equities remain down but others, including developed market equities, are up, suggesting it's too early to throw diversification on to the scrap heap of history, said Ewen Cameron Watt, London-based chief investment strategist with the BlackRock Investment Institute. He said “market positioning,” such as levels of margin buying that exceeded those of 2007, was a major factor behind the May-June decline in risk assets.
Over the past five weeks, “risk markets are up,” a sign that investors have digested Mr. Bernanke's guidance and don't see obstacles to continued growth, said John F. Vail, Tokyo-based chief global strategist with Nikko Asset Management Co.
Many market veterans insist the glass remains half full, even if volatility is likely to remain high and the investment environment tricky as the Fed unwinds quantitative easing.
There will be continued repricing of risk assets as quantitative easing unwinds, but now that Mr. Bernanke has “let the genie out of the bottle,” volatility will be driven more by fundamental factors which — unlike in May and June — should “present opportunities” investors can take advantage of, said Kevin Anderson, the Hong Kong-based head of investments, Asia Pacific, with State Street Global Advisors.
NEPC CIO Erik Knutzen said in an e-mailed response to questions that interest rates would have to rise much more quickly than currently anticipated to justify the opportunity costs of a move to cash. With the Fed committed to keeping rates low into 2015, low inflation and low global economic growth, “broad diversification still seems like the best approach,” he said.
Aon Hewitt's Ms. Sengupta said even if capital markets remain challenging the next three to five years, there are still options to improve risk-adjusted returns. One option is shifting money from bonds, which will get hit when interest rates rise, to floating-rate instruments such as bank loans.