What Monetary Policy Means for Portfolio Returns

Everyone is watching to see if—and when—the Federal Reserve will decide to cut interest rates. At its January 31 meeting, the Federal Reserve Board’s Open Market Committee left its policy rate unchanged but noted that are likely later this year if inflation nears 2%.

What this means for investment markets and long-term institutional portfolios was the topic of a webinar hosted by CIO on the same day, Investment Returns and Monetary Policy. The panel featured Andrew Junkin, CIO of the Virginia Retirement System; Carrie Green, director of equities at the Tennessee Department of Treasury; and John W. Pearce, equity portfolio manager at the Illinois Municipal Retirement Fund.

Several panelists agreed that investors are probably being too optimistic about how much the Fed is likely to cut short-term rates in 2024 and that the Fed’s cuts will most likely be smaller than what the market has priced in.

“This dynamic could lead to eventual worse outcomes as the Fed attempts to manage those expectations,” Pearce said. “So unless things change materially, I think the Fed is trying to strike a balance of cutting rates with declines in inflation, as opposed to ahead of them, because the last thing the Fed wants to do is risk losing credibility on the inflation front and let things get away from them there.”

Portfolio Returns in 2024

The equity market had experienced strong returns in 2023, and that strength is continuing into 2024, with the S&P 500 hitting all-time highs multiple times already this year, but this could be a cause for concern, according to some panelists.

“It feels to me as if the equity market is simultaneously pricing in two states of the world, the first being that we’ll have earnings growth as if times continue to be excellent, and the second being that interest rates will come down quite a bit and continue to prop up rich valuations,” Pearce said.

Junkin, however, remained cautious.

“Because I don’t expect a lot of preemptive rate cutting, rate cuts and excess of the dot plot would suggest to me that the Fed is reacting to economic conditions that have deteriorated past the point of a soft landing, and that would probably be a bad thing for earnings growth,” Junkin said. “All that makes me relatively cautious about the prospect for U.S. equities.”

Determining Portfolio Strategy

The panelists were asked how the role of the Fed and central banks globally drove their funds’ approach to asset allocation, including how they view different market capitalization and make decisions between active and passive strategies. In this environment, Green said investors want to be further allocated to smaller capitalization assets.

“They tend to have higher debt rates, more variable debt, and they’re just also incredibly well priced right now, relative to their own histories, and so we would lean into the smaller capitalization spaces, and that’s exactly where we’re overweight right now,” said Green. “But we think, fundamentally, … that a lower-interest-rate environment would be better for those smaller-capitalization assets, should the Fed take its traditional trajectory, because we know that we’ve only achieved one soft landing in our history, so the odds are it’s not going to be quite right, and we could tip

Green said the Tennessee fund prefers to move from its largely active equity allocations into passive assets as markets rally following a large drawdown—“it tends to be the junk that rallies”—and the move into passive is an opportunity to have a broader exposure to the full market and hold assets that would typically not be in the active portfolio. The TCRS holds 70% of its in active strategies and 30% in passive.

“We won’t make a massive move into passive,” Green said. “We won’t take that to 50% or swap it around or anything, but incrementally allocated dollars would be allocated to passive.”

The VRS portfolio, managed by Junkin, has 50% of its assets in private strategies. “We run a very diversified portfolio,” Junkin said. “I don’t think that we’re particularly unique in that aspect. But we have tried to get away from as much public equity volatility as is prudent and reasonable. You can’t avoid public equities as a large asset class in your portfolio, no matter what.”

Global Market Opportunities and Expectations

Respondents also discussed the geographic focus of their portfolios: Overall, their funds were all neutrally positioned globally.

“We were actually fairly neutrally positioned, globally, going into the year” said Green, who noted that throughout 2023, TCRS was underweight emerging markets but balanced its portfolio by cutting overweight U.S. equities and allocating that to emerging markets, bringing all geographies to neutral in the TCRS portfolio.

Green noted that one geography TCRS is overweight is developed markets outside of North America, which she said is an out-of-consensus view. According to Green, assets in Europe, Australasia and the Far East, particularly small-cap stocks in those regions, are undervalued. “You think that all of the bad things that can happen to EAFE have happened to EAFE at this point,” Green noted.

Skepticism of Traditional Uncorrelated Assets

Uncorrelated assets can reduce portfolio volatility and risk, making them attractive assets in volatile times. The panel members discussed what they are looking at and considering as possible sources of uncorrelated returns.

“A lot of the diversifying asset classes that public funds have allocated more and more to over the last decade or so might not be as uncorrelated as is hoped for,” Pearce said. “I think, in private markets especially, there’s a growing body of literature suggesting that diversified private equity portfolios behave similarly to leverage investments and small-cap stocks, particularly with a value bias.”

He added that he thinks “there is a lot of equity-type exposure in the quickly growing private credit market, and returns may not be as stable there as hoped by allocators. … So I think that there’s a whole lot of beta in those two asset classes more than I think people hope that there is.”

While IMRF has no allocations to hedge funds, it is increasingly interested in the asset class, according to Pearce, who noted there are some issues investing in hedge funds.

“Alternatives that are purposely designed to be uncorrelated, like certain hedge fund strategies, seem to be the best remaining option, but many public funds have shied away from that asset class post [global financial crisis of 2008 and 2009],” Pearce said. “Unfortunately, the many downsides remain: high fees, lack of transparency, incomplete access to liquidity.”

Because of the Tennessee Consolidated Retirement System’s high funded status——the fund has had little reason to explore uncorrelated assets. Funded status for the pension funds managed by TCRS ranged from 93.80% to 104.55%, as of fiscal 2023.

“The one thing that I wonder as a CIO is: When we talk about uncorrelated returns, over what time period?” Junkin asked. “If we are talking about a six-month drawdown in the equity markets, there is pretty much nothing that’s uncorrelated. We should expect some benefit from holding our risk-based investments as well, but we’re not relying on them for liquidity immediately in a crisis.”