Asset classes don’t go bankrupt, but neither do they consistently radiate value relative to the competition. Indeed, the value of any asset class waxes and wanes, providing an endless stream of opportunity and risk.
Deciding if one or the other dominates in one or more asset classes is the perennial challenge, a task that itself goes through its own peculiar cycles. Sometimes there are screaming buys, and sometimes valuations are at pinnacles of excess. Unfortunately, such extremes are rare. Most of the time, valuations are a gray area, making analysis uncomfortable and prone to error due to the whims of the moment. That, one could argue, describes the current climate for the major asset classes, where neither bargain nor excesses dominate.
The immediate source of this middling scenario is the fact that ours is a time of transition in the price of money. Interest rates, in other words, are climbing. The latest evidence comes from the world’s second-most populous country. The Reserve Bank of India (RBI) today raised its key short-term rate by 25 basis points to 6.0%–the highest in four years. The hike was billed as a pre-emptive attack on inflation’s gathering momentum on the subcontinent, subtle though it may still be at the moment. The source for the monetary anxiety remains the bull market in energy, explained RBI Governor Y.V. Reddy. “Fuel prices, which account for 35% of the increase in wholesale price index, constitute a major risk to headline inflation,” he said, as reported by India eNews.
India’s hardly alone in raising the price of money or worrying about the future for inflation. Central banks the world over are generally tightening the monetary strings, albeit after a lengthy period of easy money. Because rates around the world have been so low in real (inflation-adjusted) and absolute terms in recent years, the reaction by the capital markets has been sluggish compared with previous rounds of tightening. Indeed, the frog doesn’t jump out of the pot if the transition from cool to boiling water is slow. But at some point the frog realizes that he’s being cooked alive, at which point it may be too late to snatch victory from the jaws of defeat.
Something similar may be unfolding in the world’s capital markets, where optimism fueled by cheap money has helped investors see bull markets as the continued path of least resistance. The Federal Reserve has been more than a little complicit in this lethargic attitude adjustment, courtesy of its consistent delivery of “baby step” rate hikes over the past two years. But baby steps add up to something bigger eventually.
The fate of the major asset classes now rests with the central banks to a higher degree than we’ve seen in recent years. If the world’s most important central bank continues to squeeze the price of money, the asset class that we’ve favored on these pages for some time now will look even better. Only time will tell if that means that competing asset classes will look that much worse.
Meantime, there are the numbers. That includes the current yield of the Vanguard Prime Money Market Fund, which sits at an alluring 5.03% as we write. That is virtually identical to the current yield on the benchmark 10-year Treasury Note, as of last night’s close. But while the 10-year yield is fixed upon purchasing said bond, the appeal of money market funds in the current climate is their wondrous capacity for adjusting yields based on the prevailing monetary winds. For the moment, this strikes us as the greatest invention since the wheel, or at least the self-cleaning oven.
But even wondrous investment strategies have their limits, and we are ever attentive to the risks of expecting interest-rate hikes to roll on forever. As a strategic matter, we believe that interest rates will be higher five to ten years from now, but we’re not so sure looking out six to 12 months. At some point, the logic of locking in some of the prevailing long rates will avail itself, but not yet. For the time being, we’re still inclined to sit in an overweight cash allocation comprised primarily of money market funds and collect the rising income stream that the Fed has so generously engineered on our behalf. Eventually, we’ll reallocate that elsewhere, boosting our underweight holdings of stocks, bonds and commodities. Till then, we’re reading the tea leaves.
On that note, we recognize that it is late in the day, or so the Fed funds futures markets tells us. The August contract is priced precariously on the fence when it comes to projecting what the next FOMC meeting on August 8 will produce. Fed funds are 5.25%. Deciding if they’ll go to 5.50% on August 8 is the burning question that, we predict, will grow ever hotter in the days ahead.
But waiting still has its rewards. Just don’t confuse waiting with sleeping. The lazy, hazy days of August are nearly here, but this is no time for dozing.