From “Operation Twist” and quantitative easing to emerging markets turmoil, investors have been dealing with decisions by policymakers that have pushed the world economy into uncharted waters. As the U.S. Federal Reserve Board (the “Fed”) continues to “taper” its quantitative easing program and global markets gradually recover, the question remains: Where will yield come from when interest rates remain at their lowest level since the 1950s? We asked David Rosenberg*, Chief Economist & Strategist at Gluskin Sheff and Associates, to answer four questions that might help CFA Society Toronto members come up with some answers for uncertain times. Here’s what he told us.

Is the “buy and hold” investment strategy still relevant in today’s market environment?

I have never been a believer in a “buy and hold” strategy, as it makes the implicit assumption that things do not change. Yet change is constantly occurring. There is an optimal investment strategy and asset allocation for every investor, but it is imperative that both are constantly being reviewed and updated as changes occur. The key to a successful investment strategy is to determine what will be written in history books five years from now. Diversification is also a hallmark of a prudently managed portfolio.

Investment portfolios should be constructed in accordance with the overall market trend, which is determined by fundamentals, and liquidity, which in turn is influenced principally by central bank policy actions. But the investment process should also account for the “noise” around this primary trend, which is driven by sentiment, valuation, fund flows, and technical factors.

The other key to a successful investment strategy is identifying risks and putting in place strong risk management measures. The limitations of forecasting should also be well understood. Scenario analysis results should be used to determine likely outcomes, and a probability weighting system based on likely outcomes can be used to determine appropriate portfolio weights.

Will inflation and interest rates continue to rise over the next 12 to 24 months? What are attractive investments in this environment?

We are going to see the Fed continue to taper its monthly asset purchases. The policy threshold, however, has been expanded from the former target, an unemployment rate of 6.5 percent,¹ to a collective group of measures, including both labour and inflation data. In the meantime, the Fed remains committed to an exceptionally low range for the federal funds rate as long as the unemployment rate remains above 6.5 percent, short-term inflation is no more than 0.5 percent above its two percent longer-run goal, and longer-term inflation expectations continue to be well anchored.²

“…the central bank must also maintain a strong commitment to keeping inflation – and hence public expectations of inflation – firmly under control.”

We should consider a scenario where rising inflation causes the Fed to overshoot its long run two percent inflation target. It is worth noting that 34 states are proposing or reviewing the proposal to raise the minimum wage rate. Rental expense comprises a significant portion of the Consumer Price Index and has also been on a rising trend in the U.S. In this scenario, actions by the central bank to raise the Fed fund target rates will not be in gradual increments of 25 basis points (“bps”) as in the 2004–2006 cycle and could be closer to 50 to 100 bps.

The Fed’s decision in 2013 to increase the longer-term inflation target to 2.5 percent is a significant shift from the past three decades of monetary policy emphasis on price stability. Referring to a speech by then-Governor Ben Bernanke in 2003 on central bank actions, “… a crucial proviso is that, in conducting stabilization policy, the central bank must also maintain a strong commitment to keeping inflation—and hence, public expectations of inflation—firmly under control.”³

With the prospect of rising long-term interest rates, an expanding economy, and a mild credit default environment, a levered credit arbitrage strategy where being long credit and short government bonds to hedge for duration could be considered. Other attractive ideas include identifying companies that thrive in a rising rate environment and benefit from lower unfunded pension liabilities. If the investment focus is on inflation protection, the energy sector and gold are considered good hedges.

Canadian household debt to disposable income is currently at a new high of 163.7 percent. Should we be concerned?

Although the current consumer debt level in Canada is arguably worse than in the U.S. at its peak before the crisis, there is a huge difference in political climate between the two countries. Canadian policymakers have recently taken strong actions towards curbing excessive borrowing. In addition, it is important to understand how leverage is measured: household debt is a stock item, whereas household disposable income is a flow item. A ratio comparing a stock to a flow, e.g., debt-to-income ratio, and a ratio comparing a stock to a stock, e.g., debt-to-assets ratio, paints very different pictures of Canada’s debt levels. The debt-to-income ratio reached a new high of 163.7 percent in the third quarter of 2013⁴, whereas the debt-to-assets ratio declined to 23.5 percent due to the growth in asset values. Canadian household credit growth has also slowed to 4.0 percent over the twelve months ended January 2013 from 4.9 percent in the previous year.⁵

Another important distinction is that Canadians have primarily been borrowing to purchase assets, such as houses, as opposed to conspicuous consumption. House prices have increased significantly in recent years, but supply and demand remain balanced.⁶ Single family houses are the bedrock of the housing market and are not approaching extreme valuation levels at the national level, although pockets of overvaluation exist, such as the Toronto and Vancouver luxury condo sub-markets. Construction companies have been prudent when it comes to new developments, and the existing inventory backlog is not at extreme proportions.

Another point that is often overlooked is the budget surpluses the Canadian government is projected to run, beginning in 2015. Excess funds may be allocated to future spending increases or tax breaks, which would improve the denominator in the ratios used to measure consumer leverage levels.

Can you give our new CFA members some advice in managing their career in investments? What are the high growth areas in investment management?

Abide by and adhere to Bob Farrell’s “10 Market Rules to Remember”. Rule 9: “When all the experts and forecasters agree, something else is going to happen.”

¹ The U.S. unemployment rate in February 2013 was 7.7 percent. Federal Open Market Committee [FOMC], minutes from the meeting of March 19 & 20, 2013, pg. 2, www.federalreserve.gov.
² FOMC minutes from the meeting of September 17 & 18, 2013, pg. 11, www.federalreserve.gov.
³ “A perspective on inflation targeting.” Remarks by U.S. Federal Reserve Board Governor Ben S. Bernanke at the Annual Washington Policy Conference of the National Association of Business Economists, Washington, D.C., March 25, 2003.
⁴ Statistics Canada. Household Sector Indicators, December 2013.
⁵ Bank of Canada. Household Credit Growth, January 2014.
⁶ Canadian Real Estate Association – National Statistics, January 2014: 6.4 months of inventory “indicates that the Canadian housing market remains well-balanced.”

* David Rosenberg is the Chief Economist and Strategist for Gluskin Sheff + Associates Inc. Previously he was Chief North American Economist at Bank of America Merrill Lynch, Chief Economist and Strategist for Merrill Lynch Canada, and a Senior Economist at BMO Nesbitt Burns and The Bank of Nova Scotia.