This year has proved to be one of the most challenging investment environments in recent history.
For several decades, the investment landscape could be analyzed by focusing on two dimensions: the underlying economic fundamentals of a particular market or region, and the positioning of the investment community that participates in that market and asset class. When the market positioning is inconsistent with economic fundamentals, there historically has been an opportunity to generate returns by trading against these flows.
Over the past five years this picture has grown more complex, adding a new dimension: the increased involvement of the world's central banks via bond purchase programs. Not being guided by a “for profit” motivation has allowed all central banking flows to distort the way markets react to economic news.
More recently, the effects of the Dodd-Frank regulations have reduced dramatically the involvement of the investment banking community and opened the door for greater involvement of quantitative “market makers,” who tend to operate with smaller capital bases. The banks subsequently stopped acting as volatility mitigators, leaning against the market flows to provide liquidity.
The removal of this “shock absorber” and its replacement with a less secure source of liquidity has created a fourth dimension of complexity, that of a changing liquidity structure. What were once the most liquid securities — large-cap stocks and government bonds — now frequently overreact, notably after economic releases or changes in market psychology, much more so than what most would have expected historically. The U.S. stock market opening on Aug. 24, the German government bond sell-off in April, and the U.S. Treasury flash-crash last year highlight some recent examples.
This leaves us in a world where, even if you know with clarity the changes in central bank policy, it is very difficult to postulate how such a change would translate into asset price moves. In the new four-dimensional world, even if afforded unique insight, investment management professionals have been hard pressed to gauge the broad market response to any such change and articulate an appropriate portfolio response.
For instance, would the markets view a Fed decision to raise interest rates 25 basis points in October as a sign of confidence that the U.S. economy is strong and the Fed was ready to embark on a period of tighter monetary policy, thus long-term interest rates should rise and stocks should benefit from an optimistic economic outlook? Or, would it be viewed as a policy mistake a la 1937, and thus throw the economy over a cliff causing interest rates to fall and stock markets to crash. Would the European Central Bank, Bank of Japan and perhaps the People's Bank of China step up quantitative easing to protect their economies to counteract the Fed's actions?
What is clear is that the focus on when the Fed is going to raise its benchmark rate has misspent hours of worry as, even knowing the outcome with certainty, it is difficult to know how the broader markets will react.