Not everyone agrees with those arguments, but most concur that historically low interest rates have nowhere to go but up, which will negatively impact certain fixed-income securities. “With bonds, for much of the past 30 years you’ve been playing offense because in the U.S. there’s been this beautiful tailwind of falling interest rates,” Balasa says. “Now with interest rates set to rise at some point, you’ll have to switch from playing offense to defense. Most people on the fixed-income side aren’t accustomed to that mind-set.”
To prepare for the unknown, Balasa says his firm is trying to play both offense and defense. In fixed-income investments, the firm is minimizing bond duration to about four years, paying close attention to credit quality, looking at overseas opportunities and employing unconstrained bond funds that have flexibility to invest in any part of the bond market and can do so at any maturity point, average duration or average rating. These funds can also bet against individual bonds.
On the equity side, Balasa says investors are seemingly addicted to the easy money that’s pushing people into stocks and will likely react negatively when the Fed pulls the plug on QE. That said, he notes there aren’t a lot of viable alternatives.
“We’re not running from equities now,” he says. “We think valuations and available alternatives are such that there’s no better place to go for the lion’s share of the risk part of the portfolio.”
Don’t Try To Outguess The Fed
Lee Partridge, chief investment officer at Salient Partners, a money management firm in Houston, posits that trying to time the end of QE is a fool’s game. “You have to be in the market, but you need to be truly diversified to offset a variety of potential market conditions that can negatively impact certain asset classes,” he says.
For now, Partridge says, Salient continues to ride the tailwind to stocks provided by continuing monetary stimulus. To protect against the downside if the Fed overplays its hand with too much stimulus, the company is hedging its bet with positions in fixed income, commodities, energy infrastructure and real estate.
For its fixed-income sleeve, Salient favors the sovereign debt of Australia, Japan, the U.K., Germany and Canada. The firm also likes emerging-market debt. “Much like with natural resources, we think local-denominated debt will hold up well,” Partridge says.
Brad Thompson, chief investment officer of Stadion Money Management in Watkinsville, Ga., believes QE so far has been a friend to both investors and to the economy, even if weakness still remains in the latter. “For investors, it has made risk assets the only place to get any kind of return,” he says. Even so he acknowledges that if QE continues, the country’s balance sheet will become even more unbalanced than it already is.
Indeed, the Fed’s balance sheet has grown from total assets of $869 billion in August 2007 to $3.2 trillion as of early April 2013. According to the Federal Reserve’s Web site, the volume of securities held outright declined at the end of 2007 into 2008 as the Fed sold Treasury securities in order to increase the amount of credit it extended through liquidity facilities during the heart of the financial crisis. But the volume of securities holdings has jumped greatly since 2009 through its purchases of Treasury, agency and agency-guaranteed mortgage-backed securities during the three stages of QE.
“That type of situation is creating a bubble,” Thompson says. “But if you structure your portfolio in anticipation of the Fed ending QE and they keep extending it, you could be wrong a long time and be underinvested. That’s why we feel a risk-controlled investment strategy that’s designed to react quickly rather than predict what will happen is the most prudent way to approach this market.”