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Moves by global central banks have reduced liquidity and contributed to volatility in capital markets. This may cause some to rethink their investment strategy.

Economy and capital markets

As Fed Trims Balance Sheet, Investors Face New Volatility

  • Derek Hicks
  • 11/26/2018

In September 2017, we started a discussion about efforts by the Federal Reserve (Fed) to reduce its balance sheet after more than six years of quantitative easing (QE). At that time, the planned reduction had not yet begun, but the Fed has since started the process. We are now beginning to see the impact of the central bank’s moves and we can begin developing strategies for investors to adjust to this new market environment.

The shrinking balance sheets of central banks

As the Fed continues to raise rates, the balance sheet reduction is accelerating: in the second quarter of 2018, the Fed allowed $30 billion per month of Treasury securities and mortgage-backed bonds to mature, thereby reducing liquidity in the financial system. This rate increased to $40 billion per month in the third quarter of 2018, and to $50 billion per month in the final three months of 2018.

While central banks may or may not continue to reduce balance sheets, and consequently liquidity in the global capital markets, this uncertainty will likely cause an increase in volatility, as we have already witnessed. However, volatility causes moves in both directions, up and down. Volatility creates risk, but also opportunity.

In July 2018, David Rosenberg, chief market strategist for Gluskin Sheff, said, “By the end of next year (2019), the balance sheet will shrink by $900 billion as we play quantitative easing in reverse. This is a really big deal for risk assets.”

Back in September 2017 we pointed to a possible shakeup in the fourth quarter of 2018: “While the Fed may start QT (quantitative tightening) in September, the collective balance sheets of central banks around the world are still growing for now. Dislocations and uncertainty risk are more likely when we see net global QT, thus the bigger market impact may arrive when the European Central Bank (ECB), Bank of Japan, and other central banks decide to start QT. That could be toward the end of the fourth quarter or later.”

Right on cue, the size of the six major central bank balance sheets began to contract slightly in January 2018. Tightening monetary policy means less liquidity in the capital markets, which has contributed to the volatility we have seen in the past year. In October alone, a 100 percent equity portfolio would be down an average of 7.63 percent. A more traditional blend of 60 percent stocks and 40 percent bonds would have dropped 4.89 percent in October. Year-to-date returns are also down.

Cumulative Central Bank Balance Sheets

The role of central banks in global capital markets

Starting in early 2018, volatility returned to global markets. Since then, we have seen stretches of rolling volatility across various markets, including United States and international stock markets in the first quarter, followed by interest rate movements that spiked higher but have since reversed lower. The second quarter of this year saw international relations and trade wars cause extreme volatility across metal and agricultural commodity markets.

More recently, the strength of the U.S. dollar has created havoc in emerging markets, leading to large swings in emerging market currencies and bonds. Turkey was a frequent story in the news, but there is disruption occurring in Argentina, Brazil, and South Africa as well, to name a few.

In fact, emerging market woes began appearing late last year after the Fed began working down its balance sheet. In a June 2018 article in Financial Times, Urjit Patel, head of the Reserve Bank of India, said, “Global spillovers did not manifest themselves until October of last year. But they have been playing out vividly since the Fed started shrinking its balance sheet.”

Average Returns Through October 31, 2018

Blended Index YTD 1 Month 3 Month 6 Month 12 Month 3-Year Annualized 5-Year Annualized
100% Equity* -2.26 -7.63 -5.95 -2.21 1.41 8.86 7.60
60/40 Blend** -2.31 -4.89 -3.88 -1.40 0.02 5.73 5.29
Individual Market Index YTD 1 Month 3 Month 6 Month 12 Month 3-Year Annualized 5-Year Annualized
Bloomberg Barclays U.S. Aggregate Bond Total Return, U.S. Dollars -2.38 -0.79 -0.79 -0.19 -2.05 1.04 1.83
Russell 3000 Total Return, U.S. Dollars 2.43 -7.36 -3.95 2.70 6.60 11.27 10.81
Morgan Stanley Capital International (MSCI) All-Country World Index except United States Net Total Return, U.S. Dollars -10.97 -8.13 -9.65 -11.32 -8.24 4.37 1.63

Expect continued volatility

This review serves to highlight the phase transition the markets have undergone as global central banks — including the Fed, which manages the world’s reserve currency — attempt to unwind asset purchases on the balance sheets and move toward a tighter monetary policy.

While central banks may or may not continue to reduce balance sheets, and consequently liquidity in the global capital markets, this uncertainty will likely cause an increase in volatility, as we have already witnessed. However, volatility causes moves in both directions, up and down. Volatility creates risk, but also opportunity.

You have to look at the aggregate global liquidity (not just the Fed), to get a true picture. Recently, the ECB and the People’s Bank of China continue to provide liquidity. Until the these two key players commit to a consistent reduction in balance sheet assets, similar to what the Fed is executing now, we will likely see continued support for risk assets.

Cash as an asset class

Cash is the forgotten and largely overlooked asset class since short-term interest rates were driven to zero or even negative. With short-term rates rising, the relative value of cash reserve strategies is once again becoming relevant. Cash management can deliver return, including tax-exempt income, in addition to providing stability and capital preservation.

Debt pay-down is another strategy to consider right now, especially with short-term borrowing rates increasing at a fairly rapid pace. Paying down debt is much easier to accomplish in good, strong economic times when liquidity is plentiful. It is more difficult when the economy is soft and the markets are going down, causing your asset values to decline while debt and liability values remain constant.

How we can help

Your personal objectives, constraints, and risk tolerance should always be considered in tailoring your portfolio for an optimal outcome. CLA wealth advisory professionals can work with you to build or adjust your investment positions to address new market realities, the prospects of continuing volatility, and the opportunities that it may create.

  • Derek Hicks
  • Director, Senior Wealth Advisor
  • CLA Minneapolis
  • CliftonLarsonAllen Wealth Advisors, LLC