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Janet Yellen's success and portfolio diversification

02 February 2018

Has Janet Yellen been a successful Fed chair?

Donald Trump has not shied away from taking credit for the rise in the stock market, better economic growth and low unemployment. His critics would say that he has done relatively little, only passing his tax reform bill after nearly a year in office. In reality, the credit may be more fairly placed with Janet Yellen at the Federal Reserve ("Fed") and, to some extent, with President Obama. However, as with Trump, should we credit the success of Yellen to her predecessor Ben Bernanke who cut rates and introduced Quantitative Easing in the midst of the financial crisis? Pumping money into the economy was, in a sense, the easy part. Raising rates and reducing the Fed balance sheet without tipping the economy back into recession will be much harder. There were dire predictions that when rates started to rise it would precipitate a meltdown in bond markets, a stock market collapse and another financial crisis. Janet Yellen has overseen five quarter-point rate rises, with three more already priced in for the next year, and so far markets have been calm and risen to new highs. The managing of market expectations has been perhaps her greatest achievement but this is a job half-done. Rates have further to rise and the balance sheet reduction is only just starting. It will be the management of this over the years to come which will fall on her successor, Jerome Powell.

With unemployment low, stock markets high and the economy doing well, it is hard not to see Janet Yellen as a very successful Fed Chair but we can only judge this fully when we can assess the impact of the changes she has made in years to come. If all goes well, Trump and Powell will no doubt take the credit but for now we owe her a vote of thanks for being a steady hand on the tiller of the US economy.

Where do we seek diversification in portfolios with looming normalisation hanging over long-dated bonds?

Long-dated bonds have been a good diversifier over the years for equity markets. When equities have faced a downturn then interest rates have been likely to be lower, boosting bond prices. At these times the long end of the bond market, which is most sensitive to interest rates, provided a good balance in portfolios. The concern now is that rising interest rates put negative pressure on bond prices and then the balance is broken with bonds falling with equity markets. Rising interest rates are likely to come about with higher inflation. If this happens, index-linked bonds that are linked to inflation out-perform conventional bonds. However, they still have an element of interest rate sensitivity and so in this situation it may be better to avoid long dated issues. Short dated bonds usually move to price in rate rises and as they mature the investor benefits from higher rates. Against a strong economic background, credit spreads may narrow further enhancing returns. These investments provide a safe haven but relatively low returns. Funds that can short markets with absolute return objectives may provide another solution but require detailed analysis.

While we do not favour long bonds at the moment, there are those that predict that rate rises will trigger a collapse in equity markets. In this event, long bonds, even at the current yield, could provide significant protection in portfolios. It is not our central view but if the economy re-entered recession, we could see negative official rates in the UK, as we have seen in Europe, and further quantitative easing. The thirty year gilt, which only yields 1.9%, would return about 18% if the yield just moved back to the low yield of 2016 (1.2%). If things got really bad then yields could go to the levels previously seen in Japan in 2016 of 0.05%, if that happened then the gain would be over 50%. So while in the present circumstances other diversifiers may have their place in portfolios, we by no means rule out the use of long date government bonds in future.




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