QE plan leaves investors with nowhere to hide

The month following U.S. Federal Reserve Chairman Ben Bernanke's May 22 remarks about “tapering” the Fed's quantitative easing program saw an almost across-the-board sell-off of risk assets. Get used to it, some analysts warn.

The absence of any shelters in the storm created by Mr. Bernanke's talk of an eventual QE pullback augurs a “particularly difficult period” in the next few years for chief investment officers seeking downside protection through diversification, said Chris Siniakov, managing director and chief investment officer, Asia-Pacific, with Deutsche Asset & Wealth Management in Melbourne, Australia. Investors could find themselves with “nowhere to hide, other than cash,” he said.

That was largely the case for the month following Mr. Bernanke's remarks — until Fed assurances that economic recovery would dictate the pace of any pullback helped resuscitate sentiment.

According to Boston-based Grantham, Mayo, van Otterloo & Co. LLC, the period between May 22 and June 24 saw declines of 5.6% for the Standard & Poor's 500 index, 10.1% for the MSCI Europe Australasia Far East index, 15.3% for the MSCI Emerging Markets index, 4.4% for 10-year U.S. Treasuries, 4.5% for the Dow Jones-UBS commodity index and 7.1% for the Barclays Capital U.S. TIPS index.

With recent signs of a greater-than-expected slowdown in China further deflating investor sentiment, the month following Mr. Bernanke's comments saw both U.S. Treasuries and credit sell off together for the first time in recent memory, noted Philip Moffitt, Sydney-based head of fixed income, Asia-Pacific, at Goldman Sachs Asset Management in a telephone interview. In normal markets, money flows to “safe-haven” Treasuries from credit when volatility spikes.

The extent of the sell-off reflected investors' “pent-up anxiety” about the inevitable end of extraordinary central bank stimulus, noted Janice Sengupta, Sydney-based CIO with Aon Hewitt Pacific.

With yields below 2% the day Mr. Bernanke spoke, Treasuries — the safe haven institutional investors count on to deliver gains in “risk off” environments — suffered losses along with stocks, credit and commodities.

For “anyone running a portfolio predicated on asset class correlations being low,” the breadth of that sell-off was “pretty shocking,” noted Ben Inker, co-head of GMO's asset allocation team, in the firm's quarterly client letter on July 23.

It was a “humbling time indeed” for proponents of broad diversification, according to Cambridge-based investment consulting firm NEPC LLC, in a July 25 e-mail to clients.

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.

Meanwhile, GSAM's Mr. Moffitt said the recent failure of U.S. Treasuries to play a safe-haven role should prove temporary, perhaps another year or so. With the yield retracing 60 basis points since May, another 40 basis points or so would bring it to 3% — a level where investors could once again hold Treasuries with the expectation of risk diversification during times of volatility, he said.

Opinions differ, however, on whether an improving U.S. economy could pave the way for an end to quantitative easing that wouldn't prompt a retreat by risk assets.

Rumi Masih, managing director and senior investment strategist with BNY Mellon Investment Management's investment strategy and solutions group in New York, concedes the role of Fed policy in elevating risk asset valuations, but he argues that the stronger the recovery of the underlying economy, the less “elevated” those valuations become.

GMO's Mr. Inker said the fallout for risk assets is likely to be the same whether or not the underlying economy is vibrant. In asset segments such as stocks and real estate, GMO sees current profit margins as unsustainable — “somewhat justifiable given cash rates, but significantly overvalued if one looked at them vs. "normal' cash rates,” he said, in an e-mailed response to questions.

He predicted equities, bonds and real estate will all get hit when quantitative easing ends.