After a fantastic year of returns in the global equity markets in 2012, and a continuation of positive results from the bond markets, one would think advisors (along with clients) have little to fret about in this investment landscape. While returns have been pleasing, many clients and advisors are no doubt grappling with an undercurrent of unease about their participation in the markets and their future prospects. It would be easy to dismiss them as worrywarts or permabears, but the reality is that their concerns hint at an underlying truth that even the most bullish of investors must acknowledge—our global economy is a bit of a giant experiment right now, with central bankers and Keynesian policymakers our Dr. Frankenstein.

Since the financial crisis and Great Recession of 2008, our world economy has been the beneficiary of an unprecedented amount of interest rate manipulation and market intervention. Our financial salvation has come through the policies of easy money propagated by central bankers. However, one has to ask, can piling on more debt be the answer to fighting a debt crisis? What new asset bubbles are fermenting? Have central bankers created additional imbalances that will ultimately destabilize the system and create the next financial crisis?

Central bankers, for their part, appear confident about their ability to unwind bloated balance sheets when the time is right. They dismiss fears of runaway inflation and asset bubbles, pointing to slow global growth and weak employment data as evidence their policies are a needed support to the slow-healing world economy. They also know that accommodative monetary policy represents an important offset to the fiscal austerity measures being implemented across the developed world after years of excess.

While central bankers are determined to intercede on the behalf of growth, fiscal policymakers, on the other hand, are either bound by the rule of law or by the court of public opinion to stem the tide of unsustainable deficit spending, whether or not the global economy can withstand such efforts.

Against this backdrop, advisors and clients are searching for a path forward that allows them to participate in the markets’ upside momentum, even while acknowledging it may in part be artificial, contrived by central bank intervention. In addition, since they can’t shake their fear about a calamity around the corner, they prudently seek protection against another downturn, if and when a day of reckoning occurs.

Diversification is the most obvious answer to this dilemma, and remains one of the best ways to resolve the problem of investing in turbulent times. But as advisors and clients are all too keenly aware, mixing risk assets with so-called safety assets in appropriate proportions for each client’s particular situation may not yield the same benefits as it did in the past. For one, correlations among the various asset classes are higher than they have been in decades, thanks to macroeconomic factors such as the central bank intervention and fiscal policies. Second, central bankers’ zero interest rate policies have made safety assets not only unappetizing, but a risk in and of themselves. After all, inflation is eroding the purchasing power of zero-yielding cash. Meanwhile, fixed income appears to be living on borrowed time as yields remain artificially low following a protracted period of central bank manipulation.

Advisors and clients must therefore think carefully about their approach to asset allocation, and be creative in their implementation. Investing in a slow-growth, highly politicized market environment requires advisors to recast how they think about risk and safety and move clients out of traditional frameworks in three very important ways.

1. Consider that core stocks can be part of a safety allocation. First, for clients with medium and long-term investment horizons, advisors must begin to think about equities with a little less octane, and work hard to differentiate the risks among the asset genres. Consider core equity exposure in high-quality U.S. or global companies. These companies are strong enough to capture market share during cyclical downturns, and their pricing power rewards shareholders during periods of higher inflation. So advisors should consider them to be a measured portion of a safety allocation—in combination with traditional fixed-income investments. One could also make the same argument for high-quality dividend-paying equities.

Though the central bank actions have indeed prompted risk-taking, the markets’ positive momentum is better attributed to gradually improving business conditions. These conditions have allowed profits to climb, margins to expand, balance sheets to add massive liquidity, and corporate management to act with greater confidence.

One positive sign is that companies’ valuations are still below their median historical levels. While anemic GDP growth may suggest that those discounts are warranted, the current business cycle differs in several important respects from past cycles. (Many of the excesses that typically lead to economic weakness or stagnation are nowhere to be found.)

That means business profits are less vulnerable than they have been in past cycles, particularly now that corporate managers are more disciplined cost managers after the Great Recession.

That makes the equities of market-leading companies a core store of wealth and an acceptable allocation
of capital for the long term within one’s safety bucket.

2. Exchange interest rate risk for credit risk on bonds. In fixed-income assets, managers have almost exclusively focused on credit risk in asset allocation schemas. That focus must evolve now that interest-rate risk is likely to be an equal, if not more important, arbiter of future returns (or lack thereof). It may be best to opt either for a professionally managed individual bond portfolio for better protection against interest rate risks or for a total-return-style mutual fund manager with a flexible mandate and a track record of strong risk-adjusted returns.

To complement such core bond exposure, investors should focus on fixed-income assets that minimize interest-rate exposure, which may be more attractive for this part of the economic cycle, despite their historically higher correlations to risk markets. For example, floating-rate bank loans, which are pure credit plays, seem to be a solid choice in a period of low defaults, especially now that the trade-off in yield spreads between bank loans and high-yield corporate bonds is minimal.

Likewise, international or emerging debt exposures that focus on currency and credit returns seem to offer solid benefits.

Some investors may suggest this approach simply trades one kind of risk for another: Instead of risking low growth, they now risk heightened volatility by putting equity or credit risk assets in a safety allocation. After all, these assets are more tied to global financial market cycles than high-quality bonds are, and they are threatened by huge downdrafts in a market reversal.

3. Consider sacrificing liquidity to avoid cyclicality. For this reason, a final recommendation may be to consider investments such as real estate, private equity and hedged strategies. These asset classes depend on the success of specific investment choices and they are less tied to global market cycles. Both real estate and private equity are often smaller-scale, local investments, while hedged strategies can combine long and short investments to produce a lower net exposure to the movement of broad capital markets.

This introduces a new risk, however: Investors can’t easily cash out. But accepting reduced liquidity for a portion of their portfolio exposures may allow advisors to help clients maintain the purchasing power of their wealth, stay on track to meet their goals and avoid taking on too much cyclicality risk in pursuit of growth.
It will be years before the global economic and financial environment returns to normal. Some economists say it takes approximately seven lean years to restore real per capita GDP to its peak before a crisis. But since the Federal Reserve and other global central banks are still expanding rather than normalizing balance sheets some five years after the onset of the financial crisis, we have yet to see what is in store for the global markets when the eventual tightening process kicks in. In the meantime, advisors must stay anticipatory and opportunistic and be willing to embrace different kinds of risk (in moderation) in this brave,
new, slow-growth world. 

Michelle Knight, is Chief Economist and Managing Director of Fixed Income at Silver Bridge (www.silverbridgeadvisors).