Much ink has been spilled trying to understand the thinking behind the Federal Reserve’s balance-sheet expansion and, more importantly, how it impacts income-starved savers, especially retirees. The concerns range from forecasts of future inflation, which are used for long-range saving and spending decisions, to the ever-expanding valuations of stocks and bonds. The tough reality is we don’t know what to expect. We have never been here before.
End of QE and ZIRP?
Compounding this uncertainty is the fact that there are varying viewpoints on the trajectory of US economic growth. Some analysts see the economy, and markets, surviving mostly on the fumes of the Fed’s QE and zero-interest-rate policy, or ZIRP. Others see the economy accelerating to escape velocity, driven by an energy and manufacturing renaissance of epic proportions. These dramatic forecasts can’t both be right. Still others expect renewed growth but they have concerns about wage and inflation pressures, as well as a Fed that is way behind the curve—evoking shades of the stagflation horrors of the 1970s.
So, where are we? What do we do? There are at least three possible paths. The first is a continuation of below-trend growth and low goods and services inflation. Second, is the forecast of growth so slow that it’s really a recession, bringing with it much lower profits and interest rates and renewed fears—at the Fed at least—of a debt-deflation collapse. Third, does accelerating growth bring more profits, higher interest rates and, most likely, the end of both QE and ZIRP?
From a policy standpoint, the Fed will not stop financial repression until it gets more or less the economy that it wants. This goal is hard to grasp and hard to see. In addition, the data are measured with “noise,” as Fed Chair Janet Yellen cautions.
High Quality, Low Risk
With interest rates at all-time lows, real interest rates negative and credit spreads very tight, bonds can be as risky as stocks. Equities are fully valued everywhere except for a few areas where we see pockets of deep value. The best investment strategy is staying near the benchmark, keeping risk low and leaning toward high-quality companies while avoiding high-risk/low-liquidity strategies.
Specifically, high-quality, high dividend-paying stocks, short-duration high-yield bonds, higher-income mortgage-backed securities, and a few contrarian equity ideas such as investing in Russia, Korea and Spain. Patience remains a virtue: If and when bond yields rise and equity valuations normalize, then investment prospects will improve.
But, as John Maynard Keynes suggested, when the facts change, we change our mind. When new evidence tells us which path we are on—recession, below-trend growth or escape-velocity growth—we will change the portfolio accordingly. Further, we hope that the Fed will also decide to do something different when the facts warrant a change in policy. Until then, patience and prudent diversification are the rules of the day.