Dan Dektar: Although none of us here believe that there will be a sharp upward move in rates, there is certainly popular concern about it. We all recognize that liquidity is somewhat constrained, for several reasons. Dealers have reduced capital allocated to sales and trading because of Dodd-Frank and other financial regulations. So counterparties just aren't around to absorb risk. The market, too, is moving as a big herd driven by just a couple of factors, including the stance of monetary policy. So although we expect rates to rise gradually, we do expect considerable bouts of volatility — or what in fixed income we call spread flares, as the market gets jumpy about economic, political or monetary policy developments. So we are maintaining cash.
We would recommend that plan sponsors do the same in order to take advantage of these bouts of volatility that we're going to have and perhaps the lack of liquidity as well. We think spreads are reasonable in many asset classes for where we are in the economic cycle, but expect spreads to widen during some of these bouts of volatility in the future.
Our risk stance reflects our anticipation of volatility. I think much of the world is very, very short term in perspective on performance, whether it's due to Value-at-Risk constraints or it's a hedge fund that is marked to market. They have to do stop-loss selling when the market goes against them. Recently, we've all seen the effect on the dollar and the German bond market. The aggressive behavior of these short-term investors creates opportunities for long-term investors like ourselves and our clients. We need to be prepared and also prepare our clients for a volatile environment going forward.
Rob Waldner: We think there are two important facts that will impact the volatility and behavior of markets going forward. One is that we're coming off a very long period of zero interest rates. Our sense is that many investors have built-up positions in recent years that may need to get unwound when short-rate volatility reappears. So we would anticipate that you would get volatility — spread flares, as they have already been called — as the short end of the yield curve rises. We do think volatility overall will increase.
Second, when we talk about rising rates, we're really talking about rising interest rates in the U.S. We don't anticipate rising rates elsewhere around the world to the same extent. As a matter of fact, we think the global economy is characterized by divergence. What that means is that even while the Fed is raising rates, the other major central banks will be continuing to ease, and that easing should be supportive of fixed income assets in those regions. The divergence between the U.S. Fed and other central banks is also going to be a major contributor to volatility. We think we're in a period of volatility going forward and that would counsel keeping risk in portfolios relatively low.
We don't think specifically about cash positions because, of course, cash at the current time yields you zero. But we would keep our positions cautious. That ties in to the advice that we are giving clients, which is that market movements could be sharper and faster, leading to quick changes in spreads, particularly in less liquid conditions.
In that environment, it is beneficial to have a professional manager who can help an investor to make those allocations to increase or decrease risk. It's harder to do that quickly in the traditional asset allocation framework. It's easier to do within the context of a portfolio where the manager has the ability to increase and decrease risk.
We are asking our clients to give us the broadest set of risk parameters that they can. That means we can keep their risk profile low now, but be prepared to add to the risk if we get a situation where opportunity is created due to rising rates of volatility.
Chris Diaz: I agree that portfolio strategies should be cautious for the exact reasons that Dan and Rob point out. We are entering a new paradigm where the Fed will be raising rates. That's going to be very different than the last few years of zero interest rates. Liquidity is challenged, so I would expect volatility to stay high.
I'll focus on some other areas of risk that we see. One area is market pricing for the expectations of the Fed funds rate. We see those expectations as benign currently, more benign than the information that we have received. And while it's certainly not in our base case, any evidence of inflation or wage pressures would result in a repricing of Fed expectations, and could cause tremendous volatility and put significant pressure on risk assets.
At a time when the Fed is raising rates, we think that there's significant risk that we could see from the emerging world. We've been talking for the last decade plus about the BRICs — Brazil, Russia, India and China. Brazil is in recession, as is Russia. China is growing at half — if that — of where it was pre-financial crisis. Potentially, we could see some significant defaults in the emerging world, Venezuela for one. These are potential systematic risks that managers and investors should be aware of.