STRIKING THE RIGHT BALANCE

The Monthly Five Author Avator

Katie Nixon, CFA, CPWA®, CIMA®

Chief Investment Officer, Northern Trust Wealth Management

September 18, 2020

Your Questions Answered

With extremely low interest rates and the Fed’s latest ultra-accommodative policy announcement in mind, some investors are questioning whether they need to take more risk in their portfolios. On the other hand, concerned about US election-driven volatility, other investors worry they should reduce risk. This week, we address these concerns as well as questions about Fed policy and rising COVID-19 cases in Europe.

1

How significant is the Fed’s latest announcement that it will not raise interest rates for at least three years? Is this good news or cause for concern?

The Federal Open Market Committee ("FOMC") met this week with a clear focus on the new policy framework outlined by Fed Chair Powell at Jackson Hole several weeks ago. While the Fed has historically had a dual mandate defined as full employment and price stability as measured by a core inflation rate of 2%, it has become evident that employment can improve significantly without the expected upward pressure on inflation – a condition that has certainly characterized the post-Global Financial Crisis (“GFC”) economic recovery. Post GFC, the US experienced below-trend growth but eventually saw the unemployment rate fall to a 50-year low of 3.5% without the expected increase in inflation or inflation expectations.

That experience, along with the particular and unique contours of the post-COVID-19 economy, suggests that there is little risk of an inflation overshoot, which should allow for accommodative monetary policy even as we reach full employment. The Fed’s announcement this week was significant: The Fed Funds rate, which currently sits at 0%, will not rise for several years. That means we can expect the ultra-accommodative policy to continue to support risk-taking and push investors out on the risk curve in order to generate required/desired return. With our expectation that the US economy will continue to recover, albeit more slowly than the pace of 3Q, the new Fed framework will provide a tailwind. From a market perspective, lower for longer for even longer will continue to support elevated equity valuations.

2

What more – if anything – can the Fed do to support the economy?

While interest rate policy is the blunt instrument, the Fed has many policy tools at its disposal, and each can have an impact on the economy and on markets. Powell provided “forward guidance” this week, forecasting to the market that rates would stay put until 2024. Forward guidance is a powerful tool and can always be modified to adjust to conditions and reset market expectations if needed. Other tools include quantitative easing (“QE”), whereby the Fed buys certain assets, and lending programs, which allow it to engage directly in lending schemes designed to support the economy – most recently with the Main Street Lending Program.

These tools can be powerful alone as well as in combination, and Powell made it clear in his press conference that the FOMC stands ready to modify any of the tools if needed. Importantly, however, he always makes it clear that the Fed can lend, not spend, and that the economy right now needs some spending support in the form of more fiscal stimulus from Washington. With the clock ticking, and with the House and the Senate deeply divided, the odds of more aid from DC appear to be waning.

3

With interest rates so low, should I be taking on more risk in my portfolio to compensate for lower returns in cash/high-quality bonds?

This is a critical question, and unfortunately the answer is not as clear cut as many would like. The simple answer is, “It depends.” The first and most important decision investors will make is how much “risk control” assets are needed. Risk control assets include cash and high quality, relatively short-duration bonds. The decision will depend on a few key factors: the amount needed to fund near-term goals, the amount needed to fund goals that are “must-have” over a 1-3 year timeframe, and the amount needed to fund lifestyle goals in the event that risk asset markets become stressed.

We call the amount needed to fund lifestyle goals the “portfolio reserve.” Ultimately, the number of years of lifestyle spending that an investor would like to protect is a very personal decision and depends on a variety of factors, such as other sources of reliable income and overall risk aversion, which may encourage a larger reserve. Investors should not take risk in these important allocations. That said, we do expect that the Fed will be true to their word and that rates will remain low for a long time. This will suppress returns from cash and fixed income, so we don’t recommend that investors over-allocate to risk control beyond what they need.

4

If I am concerned about a contested election or unfavorable outcome in November, shouldn’t I take some risk off the table?

Given the expected high volume of mail-in and absentee voting, it seems likely that, at the least, the results of the US Presidential election in November will be delayed. It is also possible that the results will be contested, leading to a protracted and (even more) acrimonious period post-November. We do have historical precedent for a contested election, with the most recent example being the 2000 contest between George W. Bush and Al Gore, which eventually was settled by the Supreme Court. We know that markets hate uncertainty, and the Bush/Gore recount sent stocks down roughly 8%. We should be prepared for significant volatility in risk asset markets under a contested election scenario.

That said, we also know that risk assets will ultimately be driven by fundamentals – earnings and interest rates being key inputs. With the economic recovery expected to continue into 2021, and with the accommodative rate environment continuing well beyond, we remain constructive and would advise against making dramatic portfolio allocation changes in anticipation of a contested election. The most important thing investors can do today is to ensure that appropriate levels of cash and high-quality fixed income are held in portfolios so that forced sales of potentially depressed risk assets can be avoided during a period of short-term market stress.

5

Are you worried about the apparent COVID-19 second wave in Europe?

We continue to see clear patterns with the COVID-19 spread: More activity/movement leads to more infections. With Europe having relaxed draconian lockdown measures, the increase in infections is not completely unexpected; however, the magnitude of the growth in new cases has raised concerns, particularly from the World Health Organization. We do see some European countries selectively re-imposing restrictions, but we do not anticipate a revisiting of the strict measures taken earlier this year.

That said, more restrictions will slow the European economic recovery. This situation reinforces our premise that the global economic recovery will remain fragile and vulnerable until the successful development and distribution of a vaccine, likely in mid-2021.

Disclosures

This document is a general communication being provided for informational and educational purposes only and is not meant to be taken as investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions or inflation. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Northern Trust and its affiliates may have positions in, and may effect transactions in, the markets, contracts and related investments described herein, which positions and transactions may be in addition to, or different from, those taken in connection with the investments described herein.

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