How to Better Anticipate and Manage Future Crises

September 4th, 2014

Remarks delivered at the Bretton Woods 2014 Conference: The Founders and Future hosted by the Center for Financial Stability on September 4, 2014.

Thank you for the opportunity to address this topic. It has been an area of interest for me since the 1970s, when I worked on developing an early warning system for detecting debt problems of developing countries at the U.S. Treasury and the Federal Reserve. Thereafter, I worked with financial institutions that had considerable exposures to domestic and foreign markets. My perspective is that of an investment professional whose job is to assess opportunities and risks.

I will begin by saying the task of identifying financial crises is not easy for investors. If it were, they would be fewer and less severe. For investors to do a better job in the future, they will have to overcome the following obstacles:

(1)   Lack of adequate and timely information on exposures of borrowers and lenders. The financial system appears as a “black box” for investors, and while regulatory bodies have the authority to peer inside this box, their track record of identifying potential problems has been poor.

(2)   Lack of a conceptual framework for thinking about financial crises. Until recently, they were considered to be episodic rather than systematic, and with the principal exception of the Bank for International Settlements (BIS), economists did not focus on the credit cycle and its determinants.

(3)   Lack of economic policies to promote financial stability. Investors take their cue of what matters from policymakers; consequently, if policymakers appear unconcerned about financial stability, they will be similarly inclined. Read the rest of this entry »

The U.S. Expansion: Does Slower Growth Spell Longer Expansion?

August 14th, 2014


  • The U.S. expansion is now five years old, matching the post WWII average duration while being considerably slower in terms of growth. Skeptics cite this as evidence that the business cycle is living on borrowed time, while optimists believe the subdued recovery will prolong the expansion. A research note by J.P. Morgan sides with the optimists and concludes that the expansion should run for another 2-4 years. 
  • Fed Vice Chairman Stanley spelled out the complexity policy makers face in a speech this week. First, they must understand why aggregate demand has been unusually weak, and whether this is temporary or ongoing. Second, they must also assess the extent to which the economy’s productive potential has been lowered by declines in labor force participation and factor productivity. 
  • The view that the current expansion is likely to be prolonged is an important component of our investment strategy. While the debate about the economy’s long term potential will not be resolved for years to come, we still expect economic growth to accelerate in the next 1-2 years, as fiscal drag lessens. If so, this should underpin profit growth and the stock market while bond yields rise. 
  • One risk to our outlook is the Fed could tighten monetary policy prematurely. However, the bigger risks are geopolitical developments that could undermine recovery in Europe and/or lead to an oil supply disruption in the Middle East. 

The Case for a Prolonged Expansion

This quarter marks the fifth anniversary of the economic expansion that began in mid-2009. Based on post-war experience in which expansions have averaged five years, the current one would appear to be long in the tooth. However, when one considers the amount of slack resources in the economy and the lack of excesses, this is less evident. Read the rest of this entry »

Markets at Midyear: Waiting for a Breakout

July 8th, 2014


  • The first half of 2014 was unusually calm for financial markets. The main surprise was a 50 basis point drop in Treasury yields. Returns for investment grade and high yield bonds were about 5.5% each, while the S&P 500 Index posted a total return of 7% as it set a new record high.
  • Looking ahead, investors are unsure when market volatility will return. We continue to believe the most likely outcome is higher U.S. bond yields, as the economy regains momentum and inflation edges upward. Further stock market gains are likely to be moderate, considering how far the market has advanced in the past five years.
  • The main risks lie outside the United States, especially in the Middle East. The wild card is the prospect of an oil supply disruption that could boost oil prices and weaken the global economy.
  • We are moderately underweight in duration and overweight in credit risk in bond portfolios. For balanced portfolios, we continue to maintain a moderate overweight position in equities versus bonds.

Calm Markets Despite a Poor Start for the Economy

The most prominent feature of financial markets in the first half of this year is how calm they have been. U.S. stock market volatility, as measured by the VIX, is the lowest since the onset of the Global Financial Crisis in mid-2007. The market has not had a pullback of 10% or more for two years now. Similarly, corporate bond yields and spreads versus Treasuries are down to pre-crisis levels and currency markets have been unusually quiet. The main reason is that investors are comfortable with the fact that the Federal Reserve is not in a hurry to raise short-term interest rates, even as it winds down its bond purchase program.  Read the rest of this entry »

Falling U.S. Bond Yields: The Market Surprise for 2014

June 3rd, 2014

Note: Fort Washington Investment Advisors, Inc. (Fort Washington) is pleased to announce the appointment of Steven K. Kreider as its new Chief Investment Officer, succeeding Nicholas P. Sargen in the role effective May 30, 2014. After a long and successful tenure as Chief Investment Officer, Mr. Sargen will remain with Fort Washington and continue to serve the company as Chief Economist and Senior Investment Advisor.  In his role as Chief Economist Nick will continue to update his blog with current market and economic information.


  • Last week’s decline in Treasury yields took the 10 year yield close to 2.4%, the lowest level in a year. The move primarily reflects technical factors, as well as ongoing concerns about global weakness, especially in Europe.
  • The cumulative 60 basis point decline in bond yields this year also reflects revised expectations about U.S. monetary policy. Previously, market participants expected the federal funds rate to rise to 4.5% over the next five years; now they are pricing in the funds rate to peak at 3.5%.
  • We expect bond yields will move higher in the balance of this year as the U.S. economy regains momentum. Accordingly, we are maintaining an underweight duration position in fixed income portfolios.

What’s Behind the Decline in Yields?

Until the past few weeks, Treasury yields had fluctuated in trading ranges, with the 10 year yield centered about 2.7%. During May, the market broke out of its range, as yields fell by 25-30 basis points. The decline sent the 10 year Treasury yield near 2.4%, the level where it was a year ago. This has surprised many investors, including ourselves, considering that recent economic data suggest the U.S. economy is recovering from its first quarter slump and the Federal Reserve is continuing to scale back its bond purchase program. Read the rest of this entry »

Markets in Equilibrium: Anticipating the Next Move

May 6th, 2014


  • Our assessment at the start of 2014 was that U.S. stock and bond markets were reasonably priced, and their prospects depended on how the U.S. and global economy fared, and on Fed policy developments. So far, the principal surprise has been a 40 basis point decline in Treasury yields, which is an enigma for many investors. 
  • One year ago, when yields were roughly 100 basis points below current levels, they surged when the Fed announced it was contemplating winding down its bond purchase program. But it is unlikely the Fed will surprise investors again, and investors are comfortable that quantitative easing will be completed by the fourth quarter. 
  • Meanwhile, the strength of the U.S. economy is likely to be the key market driver in the balance of this year: Should the economy grow in the neighborhood of 3% while monthly payroll gains average 200,000+, Treasury yields are likely to resume their upward trend. Accordingly, we are underweight in duration in fixed income portfolios, and have closed out high yield positions for tactical reasons. 

Market Lull: How Much Longer?

Following a bond rally and stock market sell-off in January, U.S. financial markets have settled into narrow trading ranges in the past three months: The yield on the 10-year Treasury has been centered about 2.7%, while the S&P 500 Index has fluctuated around its level at the beginning of this year. The initial moves reflected investor concerns about a U.S. slowdown, as well as political and economic developments in several emerging economies. More recently, investors have shrugged off weaker-than-expected U.S. GDP growth in the first quarter, fears of an economic slowdown in China and other emerging economies, and heightened tensions over Ukraine. These developments suggest financial markets are in a state of equilibrium, which is likely to continue until there is a major market surprise.  Read the rest of this entry »

Marking Time

April 15th, 2014

In the wake of last year’s 100+ basis point rise in U.S. bond yields and 32% return for the stock market, financial markets took a breather this past quarter: The S&P 500 Index returned only 1.8%, roughly matching the Barclay’s Aggregate Index.  January witnessed a stock market sell-off of 4%-5% and a dip in bond yields amid concerns about the U.S. economy and emerging markets.  However, the market subsequently recouped its losses in February and went on to post a record high in March, as investors shrugged off economic data as being influenced by severe weather.

In the meantime, investors are assessing what is in store for U.S. monetary policy with Janet Yellen as the Federal Reserve’s Chair. At her first FOMC press conference, she surprised market participants by suggesting the Fed could raise short-term interest rates as soon as six months after it completed its current bond tapering operation. This triggered a rise in the front end of the Treasury yield curve. However, investors reassessed the interest rate outlook when Yellen subsequently clarified that labor market conditions are far from normal while inflation is well below the Fed’s target.  Read the rest of this entry »

Palm Beach Forum Panel: Moving Beyond Bubbles

April 7th, 2014

Remarks delivered at the Palm Beach Strategic Forum, April 7, 2014.

Mr. Chairman, thank you for the opportunity to address this session on evolving global risks and asset bubbles. My perspective is that of a Chief Investment Officer for a U.S. financial institution. This topic has become of paramount importance in the wake of the 2008-09 Global Financial Crisis and ensuing test of the euro-zone. However, it should be recognized at the outset, this was not an isolated event; there have been a series of global crises over the past 25 years that have affected policymakers and investors alike.

In my remarks, I will first examine the factors that have given rise to asset bubbles and why financial crises have become more prevalent in the past three decades. I will then consider what policies are being created to lessen the risks of financial crises and what investors can do to be protected. 

What Are the Causes of Asset Bubbles?

There are two basic approaches to this question in the literature. One approach is non-economic, and views asset bubbles as being caused by irrational exuberance, while the alternative approach links bubbles to economic factors such as excessive credit creation and unstable international capital flows: Read the rest of this entry »

Is the Fed in Play (again)?

March 24th, 2014


  • At  her first FOMC press conference as Fed Chair, Janet Yellen surprised market participants by suggesting the Fed could consider hiking interest rates as soon as six months after it completed its current tapering operation.  This would move the timetable for Fed tightening to the second quarter of 2015.  Previously, the market had been pricing in the first rate hike in the second half of the year.
  • At the same time, the Fed’s FOMC policy statement dropped the 6-1/2% unemployment rate and 2-1/2% inflation rate thresholds.  Henceforth, guidance will be more qualitative and less quantitative.
  • Our own take is that market participants had become complacent that the Fed was unlikely to tighten before the second half of 2015.  This left the front part of the yield curve vulnerable to the surprise announcement.
  • We are unsure exactly when the Fed will begin raising rates and are focusing on the economy and jobs creation.  Bond yields will likely move higher this year as the economy gains traction, with the 10 year Treasury yield headed for 3.5%. 

The Fed Alters its Guidance

Prior to this week’s FOMC meeting, market participants expected the Fed would continue to taper its bond purchase program, but investors were unsure whether the Fed would alter its forward guidance about tightening monetary policy.  The bond market’s initial reaction to the FOMC minutes was neutral, as the minutes confirmed the Fed would scale back bond purchases by an additional $10 billion per month to $55 billion.  Read the rest of this entry »

U.S. Stock Market Rally Celebrates Its Fifth Anniversary

March 11th, 2014


  • The stock market celebrated the rally that began five years ago with the S&P 500 Index reaching a record level last week that is 2.8 times above the low in March 2009.  The rally rivals that during the expansion from mid-1982 until the October 1987 crash, and is exceeded only by the technology-driven boom in the second half of the 1990s that ended in a bust. 
  • In light of these experiences, we consider the possibility that the stock market’s gains may be unsustainable.  Compared with these two prior experiences, we conclude there is less risk of a market collapse today, because valuations are not at extreme levels and there is little evidence of inflation or a credit bubble. 
  • That said, we believe the period of supra-normal returns is over; henceforth, we expect returns that are more in line with normalized profit growth of 7%-8% over the long-term.  The main risks we contemplate are the possibility of earnings disappointments and the potential for contagion in the emerging markets. 
  • Meanwhile, we continue to maintain a moderate overweight of stocks versus bonds in balanced portfolios. 

The Rally in Perspective

This week marks the anniversary of the U.S. stock market rally that began when the S&P 500 Index fell to a low of 666 on March 9, 2009.  While the market reached a record level above 1880 last week, very few professional investors anticipated how powerful the rally would become.  Moreover, the vast majority of retail investors missed it altogether as evinced by net outflows from equity mutual funds over this period. For this reason some pundits have called it the most “unloved” rally in history.  Read the rest of this entry »

Assessing Contagion Risks in Emerging Economies

February 20th, 2014


  • Emerging economies have become a focal point for investors, as a handful of countries have experienced significant currency pressures over the past year. Some observers are questioning whether this development could be the precursor of a new bout of financial contagion.
  • My own assessment is that a replay of the contagion that occurred in Latin America and Asia in the 1990s or during the euro-zone crisis is unlikely.  The reason: Currency pressures have been confined to countries with large current account deficits and/or relatively high inflation. Moreover, the external imbalances, indebtedness, and inflation rates in most emerging economies are well below levels associated with previous crises.
  • The risk of contagion cannot be ruled out entirely, however, as it is difficult to know how much leverage there is in the respective corporate sectors and banking systems.  Also, a significant slowing of China’s economy or problems in China’s financial system would likely affect emerging economies adversely.
  • In these circumstances, we believe investors need to pick and choose among emerging economies carefully: Compared to previous cycles when they moved up and down in tandem, we believe there will be greater differentiation of performance going forth.   

Increased Pressures on Emerging Market Currencies  

Over the past year there has been an ongoing build up in currency pressures for several emerging market countries. These pressures were linked initially to the Federal Reserve’s surprise announcement in May-June that it was contemplating phasing down its quantitative easing (QE) program of bond purchases. The announcement was accompanied by a surge in U.S. bond yields, and it spawned a wave of capital flight from countries that included Brazil, India, Indonesia, South Africa, and Turkey – the so-called “fragile five.”    Read the rest of this entry »