Blockbuster bond manager Michael Hasenstab has made a strongly-worded warning about market complacency, which could see many investors caught high and dry as QE is withdrawn.
As part of his 2018 outlook, Hasenstab said investors were wrongly operating with the idea that persistently low yields as a permanent condition.
‘These conditions are neither normal nor permanent and we expect the reversal of QE by the Fed to meaningfully impact financial markets in 2018 and beyond.
‘The challenge for investors in 2018 will be that the traditional diversifying relationship between bonds and risk assets may not hold true in this new cycle of US treasury yields declines.’
Hasenstab said risk assets could also decline as the ‘risk-free’ rate ratchets higher and said markets have become accustomed to exceptionally low discount rates.
‘A shift higher would materially impact how those valuations are calculated. Additionally, we’ve seen a sense of complacency develop across the asset classes as UST returns and risk asset returns have often had positive correlations, along with positive performance.
‘However, the positive outcomes achieved under the benefit of extraordinary monetary accommodation can mask the actual underlying risks in those asset categories.’
As monetary accommodation unwinds, Hasenstab said positive correlations could continue but with the opposite effect.
‘Simultaneous declines across bonds, equities, and global risk assets as we exit an unprecedented era of financial market distortions. These are the types of correlations and risks we are aiming to avoid in 2018.’
‘Investors who are not prepared for the shift from the recovery era of monetary accommodation to the expansionary post-QE era may be exposed to significant risks, in our view.’
Hasenstab said markets could see sharp corrections in UST yields in upcoming quarters, which would be similar to the magnitude and speed of adjustments that occurred during the fourth quarter of 2016.
‘We think it is critical not only to defend against current UST risks but to structure portfolios to potentially benefit as rates rise,’ he added.