- Can the stock market continue to move higher in 2014?
- How do you think monetary policy will impact the markets?
- Given where interest rates are, what are your thoughts on fixed income?
- How do you think about asset allocation today?
Q: Can the stock market continue to move higher in 2014?
A: I think we are a ways from stocks being so expensive that you have to be a seller just because they’ve gone up a lot. Historically, the kind of momentum that we saw in 2013 tends to follow through. If the market sets numerous record highs, as it did last year, it tends to be followed by a good year. In fact, if you look at how subsequent performance is after the best 10 or so years of annual returns, it tends to be good as well. So I think the knee jerk reaction to sell just because we are up a lot is probably not a deep enough analysis for going into 2014.
Another thing is that it is unusual for an equity bull market to end while unemployment is still falling. So as a very important sort of benchmark of where we stand in this cycle, and clearly we’ve not reached full employment or anything like it, regardless of how the statistics are kept, I think there are plenty of opportunities for that dynamic to continue to improve. That’s one of the things that is keeping us on the optimistic side going forward.
Q: How do you think monetary policy will impact the markets?
A: Unconventional monetary policies either last forever or they don’t. If they’re left in place, it would seem that at some point we’d be worrying about inflation. If inflation were to return in 2014, that alone would be a pretty big change in investment landscape. To the extent that these policies are not left in place forever, we don’t really know what the reaction will be to or the pace or the methodology of the withdrawal of the extraordinary measures being taken by central banks. So it’s really central bank policy and whether or not the central bankers can engineer the perfect withdrawal of this experimental stuff.
I think you’ve got to be cognizant of the interaction between Fed policy and the stock market. These unusually friendly provisions by central banks have helped propel stocks to record heights, and so when it does start to go the other way, and particularly I think when the conversation turns from tapering to when is the first rate hike, that may very well be an inflection point and we will realize that some of the equity market returns have been frontloaded by policy as opposed to being sort of smoothed out through the cycle.
We had two little windows to observe sensitivity to the inflection point in Fed policy, whether it was the first taper conversation in early summer or what we’ve been calling the taper dupe, where the Fed didn’t do anything despite everybody expecting it in September. In both cases, we saw reactions from emerging markets, both debt and equity, that were outsized relative to other things. So, if one of the prevailing themes of 2014 is an inflection point in monetary policy, then I think you have to be careful with emerging markets because that’s where the sensitivity is.
Q: Given where interest rates are, what are your thoughts on fixed income?
A: I think it is important to think about fixed income differently now than we have for decades. In other words, a large share of fixed income investments are organized against a benchmark index, and typically the risks of that benchmark come overwhelmingly from interest rate sensitivity and not from other characteristics of bonds that still could be attractive. The universe of opportunities in fixed income is wide and varied, and I think it still offers opportunity for return, but not if we organize our portfolios entirely to be about whether rates go up or down.
The other reason for owning bonds is diversification, but we have to pay attention to how correlations are moving between bonds and other risky assets, particularly stocks. Since last summer, we’ve seen a much closer positive correlation between the returns to bonds and the returns to equities, meaning you’re getting less and less diversification benefit from owning bonds. Thus, you need to think more creatively about how to protect your portfolio and diversify your risks. It might be a broader question than just fixed income. It might include explicit hedges, it might include alternative investments, and it might include more active management and less index-based investment.
Q: How do you think about asset allocation today?
A: The science of asset allocation has progressed considerably in the last 10-15 years. Investors have begun to think more carefully about ways to extract as large a benefit as possible from diversification. The traditional 60/40 portfolio isn’t as diversified as it could be because the volatility of stocks swamps the volatility of bonds. So we’ve seen an evolution in how to think about risk allocation as opposed to asset allocation. We’ve seen loosening constraints so that we can dial in the right balance and the level of risk we want using leverage or deleverage. The paradox of 2013 is that the more balanced and well diversified your portfolio, in many ways the worse you did. This was a year where you’d rather have been concentrated in equity risk and in certain kinds of equity risk, not all.
So I think the evolution now for asset allocation is to start from that enlightened idea of how to maximize the benefits of diversification, but in a context that’s more flexible, more forward looking, more adaptive to today’s market realities such as low interest rates and the vulnerability of emerging markets. That, I believe, is the next wave of innovation in asset allocation.