Wednesday 19 June 2013 by FIIG Research Legacy

Where will global growth emanate from without US growth?

Please note that the figures mentioned in this article are no longer available.


Markets have been reading things into the Federal Reserve (the Fed) that are not quite accurate, and the Fed should correct these misconceptions this week. Partly as a result of these misconceptions, equity markets have lost touch with economic reality, building in unrealistic growth expectations along with the adopting the idea that the Fed is writing a free “put” for investors. Reality, however, is very different from these optimistic expectations, and the Fed may well remind investors of a more harsh reality this week, as we outline in the next section.

After we consider the Fed, and the possibility of a reminder regarding low growth, investors need to carefully revise asset allocations, especially the timing of asset allocations. While expectations appear to have already run their course, the analysis suggests that switching between bonds and equities can have benefits in the longer term. However, one needs also to consider the shorter term, and the recent lack of momentum that is becoming evident in equity markets.

Fed preview

During the last two quarters we have witnessed weaker European growth and weaker regional growth, especially Chinese growth, and this has largely been ignored by global equity markets which are fixated on the Fed, and not what is going on in the economy. Yet, US growth is slowing as the IMF recently observed. Specifically, over the weekend the IMF criticized the recent US sequestration as both badly timed and badly designed; it will damage the longer term productivity of the US economy. As the Financial Times recently indicated,

The IMF’s comments suggest that US growth could have exceeded 3 per cent this year had Washington kept tax rates and spending steady. The Fund now expects sequestration to continue, undermining expansion through 2014 ... “The automatic spending cuts not only exert a heavy toll on growth in the short term, but the indiscriminate reductions in education, science and infrastructure spending could also reduce medium-term potential growth,” said the IMF (“IMF denounces US over fiscal tightening”, Financial Times, 14 June 2013, by Robin Harding in Washington, p.1).

These comments begin to paint the context surrounding the key release from the Fed this week. In general we expect that the Fed will try and alleviate market concerns about a withdrawal of stimulus, in the context of rapidly declining inflation, and the ongoing and very public debate, between what we refer to as “core” and non-core” fed members. More specifically, we refer to two types of members. On the one hand, the core members, who are uniformly dovish, such as Bernanke, Dudley, and Yellen. On the other hand, the non-core members, who have been vocal of late, like George and Fisher.

Figure 1 below, shows the dramatic impact of recent hawkish discussion, by non-core Fed members on the US 30 year mortgage rate, among other things. Essentially, the non-core members, through their vocal opposition to the core member views, have lifted mortgage rates dramatically, as shown below, and this rise in rates now threatens the mortgage recovery. The issue is now not about whether we have a tightening, as that has already been inflicted by market participants, but whether we need more tightening, as Figure 1 shows, (FNMA is the Federal National Mortgage Association, affectionately known in the market as “Fannie Mae”, and the graph shows the secondary market rate on a 30 year mortgage, and this is the rate many Americans pay for a new mortgage),

Two main releases from the Fed will be forthcoming:


First, the statement should focus on what the core members have been highlighting; a decline in inflation with little change to the existing description of asset purchase intentions, or rate movements. With recent weaker data, the GDP estimate for 2013, as noted in March, now looks optimistic, so we are expecting the GDP forecast to be carefully “shaved” or revised down by between 25 and 50 bps. Along with the lowering of growth should come a lowering of inflation forecasts, with the low PCE inflation readings of late. Despite the expected declines in both growth and inflation forecasts, the unemployment forecast should remain largely unchanged along with forecasts for the Fed funds rate. In other words, the revisions will speak reams about the view on the economy; growth and inflation are declining, while unemployment is not declining.

Press Conference:

Second, the press conference will be highly important and Bernanke will be more careful than last time regarding any statement about “tapering”. Again, the idea of “tapering” will be seen as being dependent on the data, and not something that can be expected at any specific time. Also, the idea that a “nomalisation” of rates is too far out to consider in any detail at this time, and that purchasing securities and changing the Fed funds rate are independent decisions, that each will require separate consideration. If inflation is trending lower, as the Fed has repeatedly pointed out, then the lesson from Japan is that “tampering” with policy is costly, both in terms of the length of the recovery and the pace of recovery. Every time the Fed interrupts the expansion it is very costly to the economy. While questions about “exit” strategies are to come, Bernanke will indicate that the decision is still far way and that nothing has been decided.

Markets have accused Bernanke of speaking out of “both sides of his mouth” of late, and the remarks in the last press conference were taken wildly out of context, and the non-core part of the Fed has had a field day; a field day that has now led to an effective tightening of policy created by the financial markets. That tightening, or rise in mortgage rates, now needs to be reversed so as to allow the recovery to gain the speed needed to enable the economy to not only crush unemployment, but also to lift inflation back to where the Fed wants it.

Dynamic asset allocation

All this discussion of the Fed is very relevant to asset allocation, as it will shape future expectations of growth. Last week we reviewed the static asset allocation methodology which showed that 75% bonds and 25% equities portfolio (the bond portfolio) has a dramatic benefit, compared to the typical “balanced” portfolio of 75% equities and 25% bonds (the equity portfolio); i.e. significantly reduced risk. Updating for recent data, the results are indeed dramatic, as follows:

  • the static bond (75% bonds/25% equities) portfolio provides 92% of the return of the equity (75% equity/25% bonds) portfolio (9.18% annual return for the bond portfolio, compared to 9.95% annual return for the equity portfolio), and
  • the static bond portfolio provides 48% of the risk of the equity) portfolio (5.75% for the bond portfolio, and 12.02% for the equity portfolio).

All that is great, yet many funds and individuals like to be a little more active; to take advantage of market movements. Hence, a dynamic asset allocation might well be taken, where the bond portfolio is preferred when equities lose momentum, and where the equity portfolio is preferred when equities gain momentum.

More specifically, we can define the rules for switching as follows:

  • use the bond portfolio when annual equity returns are lower than the 200 day moving average of annual equity returns,
  • use the equity portfolio when annual equity returns are above than the 200 day moving average of annual equity returns, and
  • assume switch costs are 10 bps, which is a little on the “skinny” side.

Now, with all this furious trading, what, one might ask, are the benefits?

If transaction costs are low, as we specified above, then the results are dramatically improved, with annual return around 12.19% (which is much higher than the static equity portfolio allocation) and an annual risk of around 7.12% (which is still much lower than the static equity allocation but higher than the static bond portfolio allocation). Here, the bond portfolio is held roughly half the time, while the equity portfolio is held roughly half the time.

We show the contrast between the active and passive allocations below in a time series of annual returns, and we note how the active allocation, or the dark blue line, participates in the upside in return but not the downside in return. By way of contrast, the passive, or static, equity portfolio allocation, or the grey line, has quite a volatile return stream, while the bond portfolio has a much less volatile return stream.

This is by no means a “perfect” model, as trading costs remain a significant issue. Specifically, if trading costs are increased to 40 bps a trade, then the return benefits fade significantly. However, we would suggest that the more interesting observation, especially before the Fed meeting this week, is what the model is saying about the current state of play.

As Figure 4 shows, equity returns have been solid of late, yet the momentum is edging closer to the 200 day average of recent returns. Specifically, the actual annual equity return (the grey line) is now moving much closer to the 200 day moving average (the light blue line). The Fed meeting, as discussed above, might stimulate a further revision down in growth expectations, causing the model to switch to the bond portfolio allocation.


At the outset, we observed that the possibilities for global growth were becoming increasingly skewed towards hopes of continued US growth. While we agree with the idea that US growth is positive, the problem is that markets have built in too much growth; they have effectively lost touch with the reality of slow to only moderate US growth. Now, as the Fed meeting approaches, we observe above that momentum in equity markets is slowing, and should trigger the allocation towards a more bond focussed portfolio quite soon, as indicated above in Figure 4. All the Fed now has to do is remind financial market participants of the risks to US growth, and the market should then come back to a more realistic pricing of growth. We argue that this is probably what the Fed will do this week, and suggest that clients should now do what all good scouts do; “be prepared”. Among other things, this means that clients should adopt a more conservative allocation skewed more to bonds, as the riskier the asset, the harder it will be hit by downward revisions to growth.