All risks are not created equal

With the winding down of the Federal Reserve's bond purchase program and expectations for rate hikes in 2015 likely to be realized, investors will reassess their risk positions. Over the past several years, investors have taken solace in the support central banks have provided the financial markets. In the U.S., yields on junk bonds remain close to historically tight levels, equity prices are hovering near all-time highs, and bank earnings are robust, despite the enormous fines the government has levied since the financial crisis.

Investors who have relied on quantitative easing as the basis for many of their investment decisions have been well-rewarded. Further, the riskier the assets, the stronger the performance has been. During this period, bad news for the economy has been viewed as good news for the markets given it meant either an increased level or extended period of stimulus. We believe investors' views today are in the process of changing. Investment decisions, at least within the U.S., must again stand on their own merit, not central bank support.

As we think about investments going forward, we need to think hard about which asset classes have benefited primarily from investment flows driven by yield-hungry investors being pushed out the risk curve and which actually have fundamentals that support their current pricing. Clearly, the market is questioning the ability of companies with weak balance sheets and questionable business models to survive in an environment of tepid growth. The days of rising tides lifting all boats are over. This process of differentiation will create the next wave of thoughtful investment opportunity for the upcoming year.

Our central view is that the accommodation will be removed gradually beginning in the middle of 2015. Subdued inflationary forces, more so than we predicted one quarter ago, and a strong U.S. dollar may anchor the Fed's patient stance. The European disinflationary forces coupled with the emerging markets slowdown have led to declines in commodity and energy prices, which have kept a lid on the recent Consumer Price Index releases. The current slack in the job market also seems sufficient to ward off wage price pressures, but we remain aware that these often have a reasonable lag. That said, the Fed will likely allow itself to stay a bit behind the curve for fear of prematurely obstructing the recovery, while adjusting its rhetoric in response to incoming economic data.

Such a policy forecast, however gradual, still results in more restrictive fiscal conditions. Much of the pricing of credit spreads and equity prices has been driven by capital flight from near-zero-return assets. As conditions tighten, it is likely that an asset allocation out of riskier high-yield bonds and equities will continue as investors will try to exit while prices are still elevated and bids exist. We expect the magnitude of such moves as well as what determines which asset classes, and subsectors therein, will underperform will ultimately depend on the pace of the tightening. A gradual slope will allow investors to buy the dips as carry will more than offset the possibility for price declines, muting the market impact.

If we look across risk assets, yields on junk bonds are still historically low because of a combination of low default rates and yield-starved investors. Spreads on mortgage-backed securities are near all-time lows as many investors are aware they are selling convexity but are ignoring the risk as rate volatility is diminished and they need yield in whatever form they can get it. Equity returns on collateralized loan obligations have declined from the high teens to low teens on the heels of low default rates and record demand. These are all indications that in the event of a breakout of the recent rate range, in either direction, investors will be disappointed. Should rates rise more rapidly, a faster than expected tightening by the Fed might increase risk premiums as investors shed equity, credit and duration risk. On the other hand, should the economy stall following the end of QE, the weaker economic outlook will increase and default expectations will roil the credit markets.

Given the markets are very data-dependent with yields low and spreads tight, one needs to successfully trade the noise to generate meaningful returns. It is very difficult to say today which economic path will be correct: Does the world slow and tip into another global recession or does the U.S. economy sustain its growth and a more normal cycle resumes?

What we do know for certain is that the markets, given their reduced secondary market liquidity due to Dodd-Frank regulations, will more often overreact. Asset prices will be pushed too far in either direction as news is digested and participants sell unwanted positions quickly. An investor should invest with a view to reacting to these flows, take positions selectively, strategically hedge, and overtime redistribute them to end buyers. We believe this creates an improved opportunity set for market-neutral strategies from the increased frequency of temporary dislocations.

As the central banks' policies diverge over the next few years, investors will be reminded yet again that all risks are not created equal.

Basil Williams is co-CIO of Mariner Investment Group LLC, based in New York.