Greg Peacock: Need for investor caution remains after Fed move

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The bull case is that tapering is only happening because of the US economy is improving. File photo / Getty Images
The bull case is that tapering is only happening because of the US economy is improving. File photo / Getty Images

It's finally happened and the world hasn't ended. "Tapering" is under way and the sun still rises in the east. This much-anticipated event, the beginning of the end of quantitative easing, which was viewed with trepidation by most investors, did actually begin in December. Not that many noticed.

In terms of its impact on markets, it has been a damp squib to date. All of which doesn't help much in terms of determining what happens next. How should investors position their portfolios for the year ahead?

The most important point here is that no one really knows. Certainly that is partly because withdrawing from such a massive programme of money printing has never happened before. But there's an even more fundamental issue, which is that in financial markets no one ever knows with certainty exactly what's going to happen, even in normal conditions.

Those who claim certainty are fools and the people who really do have certainty are insider traders.

The wise answer to where the New Zealand dollar or sharemarket will end the year is not given to three decimal places - it is to admit to being unsure.

J.P. Morgan's famous response to a question about the outlook for the US equity market was that it will "fluctuate". Investing is about the balance of probabilities rather than certainties. The great investors understand this, and how they manage situations when they do get it wrong is often what defines their greatness. In the context of tapering it is, arguably, even harder to crystal ball-gaze than usual. These are not normal times and uncertainties abound.

Scenario analysis is a valuable tool to use in circumstances such as these. Testing the likely impact of a range of possible outcomes is preferable to just hoping that all will be well in the end. So what are the potential effects of tapering?

The worst, or bear case, is that bond yields rise significantly as the biggest buyer, the US Federal Reserve, steadily reduces its monthly bond purchases to zero, and that this, in turn, drags equity markets lower. Possibly much lower. Those owning the traditional balanced portfolio of bonds and equities are faced with a rare lose/lose situation. Losses from both bonds and equities have happened only once in the past 30 years, in 1994.

The best, or bull case, is that tapering is only happening at all because the US economy is improving and so no longer needs stimulus but that improvement does not imply higher interest rates any time soon. Fed chairman Ben Bernanke has been promoting this interpretation. He does so specifically to engineer a benign market reaction, having been surprised by the bond market's dramatic sell-off in May's so-called "taper tantrum" (when Bernanke suggested tapering was imminent). Nevertheless, under this most rosy of scenarios, equities appreciate on solid earnings, while price/earnings multiples expand and bonds do very little. Those with the traditional bond/equity portfolio do nicely.

The most likely outcome, though, lies somewhere between these two extremes. Equities are most likely not to repeat recent strong gains but should perform solidly enough, with global bonds roughly breaking even.

The goal therefore is to construct a portfolio that does well under the most likely outcome but can cope with both the bear scenario (bond and equity losses), or the Goldilocks scenario (an economy neither too hot nor too cold) of surging equities.

Even though tapering is very much an overseas event, it affects local investments too. Domestic assets will be affected meaningfully by both the bear and bull outcomes, in particular. New Zealand assets are very unlikely to be immune from these global drivers.

Simply reacting to events as they unfold, as some managers do, is not good enough. If the bear scenario unfolds, taking action means selling equities at a lower price and buying bonds at prices higher than are available today. If the bull scenario plays out, that means buying equities and selling bonds at worse prices.

There's an excellent chance of selling equities, for example, thinking they're going lower, only to see them move higher again. It is far better to position your portfolio in advance, to be proactive rather than reactive. To do so requires identification of an all-weather asset class, one capable of performing in bull or bear markets, or something in between. That asset class is not property because higher bond yields mean higher mortgage rates. The asset class is alternative assets (and I must declare a vested interest in alternatives here).

Alternative investments comprise a wide range of investments, some quite esoteric (collectables, forestry, aircraft leasing and insurance-linked securities) and others less so (commodities, private equity and hedge funds). The way to protect against the risks of traditional bonds and equities is to diversify into the non-traditional. Most of the world's largest institutional investors already do so. In fact, the average weighting to alternatives in 2012 for 831 US College Endowment funds was an impressively high 54 per cent. This is not an easy asset class for private investors to access directly, nor a familiar one. Their adviser or a specialist provider should be able to assist.

Greg Peacock is head of research at NZAM, an Auckland-based global investment management firm that invests in alternative assets.

- NZ Herald

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