Central bank reversal puts managers on unsteady path

As extraordinarily accommodative monetary policies by three central banks begin to slow, halt and reverse, money managers are becoming increasingly cautious and preparing for the next — and unprecedented — phase in the global economic cycle.

The U.S. Federal Reserve is already on the path to monetary policy tightening, with interest rate hikes being undertaken and signaled for the coming months. The​ European Central Bank last week announced it would reduce the pace of asset purchases starting in January. And the Bank of England, grappling with the country's highest inflation rate in five years and a difficult negotiation over the country's exit from the European Union, has signaled a willingness to raise interest rates in the coming months.

A reversal in central bank policies "is pivotal to a degree; reduced official support for asset prices is clearly a concern," said Lucinda Downing, senior asset allocation analyst at Aon Hewitt Ltd., based in London. Ms. Downing said the moves by central banks add to a number of other concerns for markets, although "the mood in the market is still upbeat, even though ​ central banks trimming balance sheets is ahead of us."

A number of money management executives highlighted the inflection point in monetary policy as a point of caution.

Part of the issue is that the extraordinary measures taken under quantitative easing across the globe "by definition means the unwinding is also unprecedented," said David Lafferty, Boston-based senior vice president, chief market strategist at Natixis Global Asset Management. "We are in uncharted territory here. We haven't fully assessed what the buying of assets has done. If we don't fully understand the ramifications of the purchases, it is difficult (to assess) the effects of unwinding. My head says this is going to be very slow, but my heart says it is hard to let the air out of a balloon very slowly."

Quantitative easing has led to "an extra $6 trillion sloshing about in the system. You don't have to pull a lot of it back to potentially do damage," Mr. Lafferty said.

While he isn't expecting a "calamity" in risk assets, investors must be prepared for it. "There will be a market reaction at some point, even if (it is) small. It is how that ripples through the system, the secondary effect, that becomes worrisome," Mr. Lafferty added. The firm is making use of options hedging as one way to prepare.

Hermes Investment Management's Fraser Lundie, co-head of credit in London, said investors might be entering a new phase in markets, with inflation expectations bottoming out and quantitative easing tapering.

That means "that negative relationship between government bonds and everything else is perhaps not quite as certain as it has been in the past," he said.

There are a number of reasons to be pessimistic in today's bond markets, said Tim Haywood, investment director, business-unit head for fixed income at GAM in London, including "a sense that inflation is creeping up … very low absolute yields … little volatility," and that many equities might perform better than their bond equivalents.

What's more, interest rates no longer are falling, yield curves are "pretty flat" and "QE is stopping, slowing or being reversed. The great vacuum-cleaning operation of fixed-income across the world is turning," he said.

However, there are moves that can be made in the face of unwinding QE. "And you need to be open-minded, and look at different ways of doing things," added Mr. Haywood.​

The use of options and hedges on equity positions, running short-duration and buying forms of credit protection were highlighted as moves made within money managers' portfolios.

For credit, Mr. Lundie thinks the new phase of markets given tightening monetary policies "means achieving the type of risk-adjusted return of the past is going to be a lot harder in the future, because of the importance of that relationship between the government bond component of a credit security and the spread part. … Ultimately the ability to rely purely on government bonds and duration to bail you out in a sell-off is clearly not likely to be there as it was in the past."

Hermes executives are making a number of moves right now: on the "bearish side we're looking for opportunities in companies that we think are going to be particularly hurt by a more volatile (or higher) interest rate environment" and expressing views accordingly, he said.

Another move is to avoid "negative convex securities," bonds that are callable in short order by a company.

On the opportunities side, for Mr. Lundie, it's about being "very much away from the consensus in terms of the way people are allocating to credit right now — which is going short-duration crazy, and very much on the loan side as well. Levered loans and short duration have been dominating credit allocations," he said, and some investors do not appreciate that banks have spotted this demand and structured deals to satisfy it. "Most of the new issue recently has been specifically designed to be in that front end of the curve — that combined, to me, means the opportunity is further out the curve," added Mr. Lundie.

David Riley, head of credit strategy at BlueBay Asset Management in London, said the fourth quarter is "pivotal" in terms of policies; the uncertainties lie in the impact on longer-term bond yields, peripheral bonds and corporate credit. Executives at BlueBay have been taking profit on some risk positions.

"We have not gone to cash, we are still long risk, but nonetheless (we have taken) some profits, got slightly less offensive in (our) portfolio positioning. And we are basically running neutral to slightly short interest rate risk." Essentially, the firm is neutral on European rates since the ECB extended quantitative easing as executives expected to late 2018, "and with interest rates low, there is a limit to how far bond rates can raise higher," said Mr. Riley.

The firm also put hedges in place regarding U.S. interest rate rises.

"We still think the market is underpricing the Fed and the interest rate path. You cannot discount the possibility that (the Fed doing more than expected) becomes a speed bump for credit and equity and emerging markets as well."

But it is important to remain invested, added Patrick Thomson, head of international institutional clients at J.P. Morgan Asset Management in London. "It is very much uppermost in clients' minds. There is a bit of asymmetry in some respects: central banks quite rightly appointed … a successful set of (moves) that allowed stability in financial markets, but we expect the exiting of those strategies will lead to more volatility … particularly in a world of heightened valuations."

Remaining diversified is key, ensuring exposure to certain risks is not "multiplied" among holdings in portfolios; stress testing portfolios; and "it is very important to remain invested. We think timing this stuff makes no sense at all. Investors are long term, can ride out short-term volatility and take advantage of those distortions to perhaps pick up asset classes that have suffered distortions (and where) others have exited," Mr. Thomson added.

GAM's Mr. Haywood said not only can investors buy credit protection, but "insurance on insurance" by buying receivers. "You can protect against credit getting even tighter for very little money. That is appealing as the absolute entry level of buying credit protection is so low — if something shocking were to happen, the combination is a cheap parachute," said Mr. Haywood.

Equities are also working to some managers' benefit. Maya Bhandari, portfolio manager, multiasset, at Columbia Threadneedle Investments in London, said portfolio managers at the firm do not see central bank moves as posing a challenge for all risk assets, with equities carrying a higher risk premium than corporate credit, for example. As such, they are "positioned to take advantage of good corporate earnings in Japan, Europe ex-U.K. and Asian emerging markets."

Portfolio managers have run "lite-duration" in portfolios for a number of years, "but it's certainly a view I would hold with increasing conviction" given the backdrop of a tightening Federal Reserve, yet dovish market pricing and negative term premiums, said Ms. Bhandari.

And GAM's Mr. Haywood added managers are contemplating that equities might further outpace fixed income through holding convertible bonds. "What we're now trying to do is remove the corporate bond component as interest rates are low, and credit spreads are tight — that part no longer has much value, but the equity warrant might have in strongly rising markets."

For Ms. Downing and Aon Hewitt, however, now is not a good time to "chase the equity bull, even though it is very tempting as corporate earnings and economic data are quite good. Central bank actions are one reason to say don't chase the equity bull."