In October, and after months of speculation regarding the future leadership of the US Federal Reserve, President Bush finally announced the name of the person who will replace Alan Greenspan when he retires early next year.
The man is question is Ben Bernanke, a member of the board of governors of the Fed and chairman of the president’s Council of Economics. Mr Bernanke was the market’s favourite candidate, representing the continuity of Mr Greenspan’s work, however most economists and investment professionals expects the transition period to be volatile.
On the day Mr Bernanke’s nomination was announced, US equity prices rose and bond prices fell. According to Tony Dolphin, director of economics and strategy at Henderson Global Investors, this could be seen as the market taking a view that he might be less hawkish when fighting inflation, probably because of his known fears of the effects of deflation. However, Mr Dolphin believes that this reaction is likely to be wrong, adding that in effect the differences between Mr Greenspan’s interest rates policy and Mr Bernanke’s may be very small.
Fears unfounded
After the controversy following Mr Bush’s nomination of Harriet Miers to the Supreme Court, there was a fear in the market that the new Fed job could land on an unknown or unqualified candidate. “So there was a certain amount of relief that that didn’t happen,” he says.
Mr Dolphin says that a lot of people are now focusing on Mr Bernanke’s academic credentials as an inflation target theorist. “But if you look at his recent speeches I actually agree with his assessment of the US economy and this is that inflation is not too much of a concern at the moment.” He says that those that still talk about Mr Bernanke as a “low inflation man” have been possibly ignoring some of his most recent comments.
Whatever Mr Bernanke is planning to do during his first year in charge of the Fed could have a major impact on the world’s economy as a whole and on investors’ portfolios.
“We will be monitoring very carefully every speech that comes out, because it is important for us to maintain a close connection with what is going on in order to ensure that we are confident that there are not going to be any surprises,” Mr Dolphin explains. “A bad central banker has the potential to upset markets a lot. On the other hand, a good central banker is one that keeps things relatively calm and under control and avoids crisis. You don’t necessarily want to be seen as a hero.”
During this year, monetary policy in the US has been very important for the US bond market. With interest rates expected to go up to 4.75 or 5 per cent – or even higher – central banks are trying to target inflation expectations to make people feel there is no possibility of inflation getting out of control. This has created a fairly attractive yield environment in the US, which gives investors a fair amount of confidence that there is going to be reasonable returns coming from the country’s fixed income market.
“I think in Europe this trend is less under way. The US is a more attractive market for us than Europe or Japan,” Mr Dolphin notes.
Interest rate concerns
 Toby Nangle, Baring AM | Investors’ concerns about rising interest rates are starting to be felt now, as Toby Nangle, director of fixed income at Baring Asset Management explains. “While interest rates were going up from 1 per cent to 3.5 or 4 per cent investors were very relaxed because they had always regarded rates so low as being abnormal.”This perception of abnormality meant investors weren’t expecting these low rates to be maintained and therefore they didn’t build their expectations around them. |
“I think from here on in investors are beginning to ask themselves if the Fed is taking rates above a normal or neutral rate into a territory where you can actually describe policy as tight. If they are doing that then they are potentially putting pressure in the economy next year which will be felt in profits and by the equity markets,” Mr Nangle explains. “I think part of the reason why the US market has lagged behind this year is that people are beginning to worry about that a bit.”
The bond markets remain reasonably relaxed, since they can look through this tightening environment to the prospects of slower growth with inflation staying under control. “If anything this situation is causing investors in the US to be a little more tilted towards bonds and against equities, which is the opposite than everyone else in the world.”
The growth in the US economy has been providing support for the global economy enabling equity investors in Europe and Asia to enjoy very strong gains in their portfolios. But if US interest rates are taken any higher, we might see European and Asian interest rates rising too. “Obviously in such a scenario you would begin to see a global squeeze on the economy, but I don’t think that would stop equity markets going up because you will still have some decent profit growth.” Mr Nangle adds: “But the rising interest rates would hold down valuations and certainly you wouldn’t expect to see the same sort of gains we’ve seen in Europe and Asia this year repeated next year.”
The impact of rising interest rates in the fixed income area could be different depending on the segment of the market. According to Mr Nangle, if interest rates rise globally there will be more upper pressure on yields, “but not a huge amount, because the markets never really expected interest rates to stay at the low level they were at.”
However riskier areas within the fixed income markets could be more significantly affected, including investments in corporate bonds, high yield and emerging market debt. Low interest rates investors have been prepared to take on more risk in the desire to attract more returns and now, as short-term interest rates go up, they might start to question whether this approach still makes sense.
“For the bulk of bond investments in sovereign [rising interest rates] are not a problem, but for some of these riskier bond assets that people have been moving into, next year could be when they discover how risky they are,” Mr Nangle says.
Emerging market debt could be considered as one of these riskier fixed income investments whose performance could be negatively affected by a slow down in global economy. However, for Owi Ruivivar, vice president, sovereign research, emerging market debt, at Goldman Sachs Asset Management’s team, it is necessary to differentiate three components to return performance to analyse how the asset class could be behaving in the near future. The first element would be the co-movements with US treasuries, the second the changes in spread, and the third, the carry trade that Ms Ruivivar sees as “the spread that you pick up for being in emerging markets.”
“On a carry perspective I think fundamentals and technicals can keep us around the mid-200 range,” she explains. “Regarding spread changes going forward, I see them as being pretty muted. I think that, given the scenario that we anticipate in the global economy which is relatively benign, with the Fed remaining quite conservative and pretty credible, inflation risks will be contained and the growth outlook is pretty optimistic.”
Finally, regarding the co-movements with US treasuries, Ms Ruivivar says: “I am not an expert in US treasury and I rely on those who are. My understanding is that the consensus view is that volatility is going to be part of our life especially with this hand over in the Fed.” Ms Ruivivar says that this is one of the reasons why she doesn’t feel comfortable giving a number for emerging market debt return expectations. “This third element has a huge standard error attributed to it, because volatility is already expected to be quite high. So this aspect is going to be driving a lot of return performance in emerging markets going forward and I think it will be the same for other credit products.”
Volatility benefactors
Hedge funds, on the other hand, could benefit in a volatile market, as Justin Dew, director and senior hedge fund specialist for the portfolio services group at Standard & Poor’s. “If those who are expecting volatility are right, and I would argue that they probably are, that should be positive for hedge fund investing because at the end of the day volatility is a positive things for most types of hedge fund strategies,” he says. “As long as volatility is directional in nature, that is a good environment for hedge funds.”
It is now a question of wait and see how Mr Bernanke leads the Fed during his first months in charge, but in general the market has welcomed its nomination. Most believe things will remain pretty unchanged unless a major economic or political crisis happens during his first year on the job. “I think in that instance the market would miss the reassurance of having around Alan Greenspan who has been through several crisis in his career and handled them well,” Mr Nangle says.
