his article originally appeared in the online edition of Pensions & Investments on 25 June 2013.
It is that time of the year again. As school schedules give way to summer vacations, many families will be packing up the SUV to head to one of this nation’s amazing national parks. Years ago, my young family traveled to Yellowstone National Park, home of Yogi Bear and Old Faithful. The requisite float trip down the Snake River was arranged and a good time was had by all – a bit of spray but nothing too jarring. Only days later, I returned to the Snake River and had the ride of a lifetime. Setting off a few miles upstream from my prior journey, we maneuvered around boulders and sharp drops as whitewater waves rammed the raft.
The experience offers insights into navigating the rough patches of today’s markets. On the Snake River, staying the course – and skillful navigation – led to calmer waters. Although markets are less predictable than river currents, the investors most likely to reach their long-term destinations are those who remain invested and avoid short-term decisions that may take them off course.
Despite recent events, PIMCO doesn’t anticipate a sustained bear market in bonds in the immediate period ahead. As CEO and Co-CIO Mohamed A. El-Erian described in our recent Secular Outlook, “New Normal … Morphing,” we do not see near-term catalysts that would lead to sustainable, private sector, above-trend economic growth nor price pressures that would lead to rising inflation. We envision the global economy muddling through on a low growth, low inflation path for the next several years.
Rather, the market’s recent volatility is rooted in the extraordinary liquidity pumped into the global system by the major central banks. For the last several quarters, these policies have buoyed all financial asset prices. They led the market to greet each piece of bad news with glee, a signal that monetary authorities would continue to supply ever-larger amounts of zero-interest dollars, euro, sterling and yen. Then, in Japan, “Abenomics” brought a whole new meaning to quantitative easing, rapidly propelling the yen downward and the Nikkei to multi-year highs, in the newest incarnation of the Japan carry trade. (We have written extensively on how hyperactive monetary policy, while largely failing to deliver desired growth outcomes, has incentivized investors to move out the risk spectrum, resulting in distended valuations and inflated asset prices. One recent example is Bill Gross’ latest Investment Outlook, “Wounded Heart.”)
This was the context in which talk that the Fed might make good on its statement to reduce bond purchases or the Bank of Japan might fail in its mission triggered a downward spiral of liquidity withdrawal and declining asset prices. It’s a process which can quickly become messy and indiscriminate. Volatility can spike and seemingly haphazard selling can become pervasive; selling can beget more selling.
As I learned on the Snake River, though, the primary objective is to keep the raft upright and headed down river. Similarly, for investors to reach their goals, maintaining proper diversification is paramount. Although much attention has been paid to the risks and rewards of fixed income, it is important to remember that bonds have many attributes that can dampen return volatility and enhance risk-adjusted returns. On the whole, fixed income remains among the most liquid asset classes. Bonds deliver a reliable source of income absent default. They also can hedge risks: Nominal bonds hedge against deflation risk, whereas inflation-linked bonds can offset the impact of rising inflation.
For rafters to succeed, oarsmen must pull together and rely on a knowledgeable and steady hand at the helm. For investors, active managers serve that role. They can use time-tested methods to design portfolios that seek to add value and minimize risk. By their nature, indiscriminate sell-offs create dislocations and mispricings. But when markets do ultimately normalize, this stored alpha has the potential to come home by way of outsized returns.
Lastly, when fear (and greed) rules the markets, investors who can stand back from the fray and apply informed and reasoned decision-making can better protect their capital and position themselves for future opportunities. As with the Snake River rapids, planning, discipline and perspective are essential.