The real cause of last week's market losses: investor anxiety about monetary policy changes. As I wrote in my latest weekly commentary piece, in a world where risky assets have been driven higher mostly by ultra-low interest rates rather than by strong earnings, investors are increasingly focusing their attention on when the easy money will end.
While investors typically watch the Federal Reserve and other large central banks, their focus has recently turned into an obsession. Hypersensitive investors now parse central bank testimony for the slightest change in language or tone. The fixation on loose monetary policy is one of the main reasons investors have become enamored with U.S. and Japanese markets. The Fed and BOJ are implementing the world's most aggressive monetary policy.
So what do I do with my money in response? Here are three investing implications of this fixation on the Fed:
1. While stocks can still move higher this year, expect more market volatility. As we get into the summer months and closer to some moderate change in Fed policy, volatility is likely to increase as investors used to easy money adapt to tightening monetary policy. In addition, as illustrated by last week's losses and the steep sell off in Japan, any confusion over central bank policy is likely to cause an increase in volatility. This doesn't mean that investors should abandon stocks; rather, they should simply be prepared for more bumps along the way.
2. Be cautious of U.S. small caps and U.S. dividend stocks, especially defensive ones such as utilities. These are equity segments whose valuations have been most distorted by unusual monetary conditions.
3. Emphasize credit over Treasuries. With Treasury yields likely to creep higher throughout the year as the Fed gradually changes its policy, investors should consider minimizing their exposure to Treasuries and opting instead for more attractive credit sectors like high-yield and BBB-rated bonds. These fixed-income sectors are accessible through the iShares High Yield Corporate Bond Fund (HYG) and the iShares Baa-Ba Rated Corporate Bond Fund (QLTB).
In short, investors can expect that market performance in coming months is likely going to continue to be all about the money -- central banks' money, that is.
Source: BlackRock, Bloomberg.
Disclosure: The author is long HYG.
Disclaimer: Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.