Every time an event causes a significant market move, like the recent ‘tapering’ discussion has done to international markets, the difficult question to answer is whether it is a transitory of a more permanent phenomenon. If the discussion is mostly noise, without a relevant impact on fundamentals, then it is bound to pass and making portfolio changes would prove a costly mistake. The volatility of the last 2 weeks shows how difficult it is to answer that question in the context of an unprecedented monetary expansion that some fear it is about to start ebbing.

The size of the monetary expansion since the 2008 has no historical comparison. There had been no real analysis of such a scenario before the experiment was put to work. What real effect has this experiment had is a matter of serious debate, and will remain a mystery for some time. It is clearly impossible to argue that it has had no impact in markets. Some believe that markets got where they are mostly due to the Fed. Thus, when the Fed Minutes were release on May 22nd, showing the FOMC had discussed scenarios for reducing their securities purchases, the markets took that as a signal that the beginning of the end of monetary expansion was near. The end of monetary expansion is seen as a one-way trip that produces serious re-pricing of markets that have been lifted by the powerful tide of monetary expansion.

The previous paragraph tries to illustrate the point that whenever market participants got a signal that it is time to plan for the retracement of monetary expansion that they would panic and sell. This is to some extent what happened since May 22nd, even though the message the Fed was trying to send was a much milder and conditional one. The Fed has only started to debate how and when would reduce the pace of expansion. Is this debate a signal worth reacting to, or just noise? We believe it is both: noise in the short-term, signal for the medium-term. Monetary policy has to normalize, and it is most likely going to be a very very long process (years, many years), with bouts of volatility every now and then, mostly as the result of the difficulty to think about this unwind, as well as the natural tendency of markets to move much faster than what most would prefer. Here are a few important issues to keep in mind, in an effort to prevent any over-reaction.

– In the current low inflation environment, any decision by the Fed to reduce the pace of expansion would only happen once the economy has shown clear signs of a stable and consistent improvement, especially in the job market.

– The Fed is obviously not focused only on equity markets, but they do pay attention to them and understand that the improvements since 2009 have helped rebuild confidence through the feedback loop of the wealth effect.

– The Fed has signal that the bulk of the balance sheet might never be sold, as it can be let mature. Thus, any reduction in the Fed’s balance sheet is bound to happen only when the economy is growing steadily. And the Fed raising rates? Nobody thinks that can happen this year, not even next year, and inflation is clearly not making this a difficult decision.

– All throughout the last 2 weeks of falling markets, economic data has continued to confirm that the world continues its steady improvement grind, especially in the USA, and surprisingly positive in Europe. China remains a question mark.

– Much of what happened since May 22nd is the result of market dynamics when an event triggers the unwind of crowded trades (e.g. Japan). Obviously, this is easier to say ex-post than to foresee ex-ante, which is why tolerating volatility is sometimes better than trying to get out and come back in, as timing those moves tends to prove elusive (and produces the undesirable phenomenon called ‘negative convexity’, which can be translated as ‘sell low, buy back high’).

– It can be argued that equity markets remain inexpensive, especially in G7. With rates at historical lows, and their most likely direction is higher, equities and other real assets are the natural beneficiaries of the global portfolio allocation process. This is clearly our medium-term mindset, which is why reducing equities in an episode like this one does not make sense unless one could foresee it perfectly.

– Emerging markets have been the biggest casualty of these moves. As international liquidity stops growing, countries that have benefited from capital inflows and continue to have such needs could be vulnerable. The recent moves in equity markets are an over-reaction in that sense, but point to a medium-term challenge, as this reasoning would push allocations to concentrate risk in the US and maybe Europe. Relative economic performance over the next few months/quarters should be determinant. High beta high duration fixed income segments can be identified as clear danger zone. Equity markets is less clear, though we should not neglect an incipient trend of capital outflows from EM equities.

In sum, the volatility of the last 2-3 weeks can be nerve-wracking and lead to over-reactions. It is almost impossible not to make mistakes. We try to avoid over-reactions while maintaining an open mind. We were well prepared for the rates move, as we had eliminated most of the duration from portfolios, and have reduced EM currencies significantly. Have had high levels of liquidity. But we remained invested (though with a conservative stance) and continue to look for opportunities to reallocate to real assets, away from debt and other nominal assets.

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