There is an old saying that “bull markets don’t die of old age, they get murdered by central banks.” This makes a lot of sense, given that central banks control short-term borrowing rates and use that policy tool as a way to influence the economic cycle in an orderly fashion. The Federal Reserve (arguably the world’s most important central bank) has two mandates: maximum employment and stable prices. Given how much of a challenge it is to forecast what the natural rate of unemployment is and where the current unemployment rate is relative to this measure, central banks mainly concern themselves with price stability, as this is (debatably) an easier bogey to hit.

Since the financial crisis of 2008, unorthodox monetary policy from central banks around the world has put downward pressure on interest rates. The lower yields provided by fixed income products have resulted in investors needing to “move along the risk spectrum” and allocate more of their assets in equities (or higher expected return asset classes) in order to achieve the rates of return they have imposed on themselves. This shift in the investment environment has been a challenging one for “savers” or those with low-risk profiles, as well as pension plans that need to hit target rates of return in order to meet their projected pension liabilities.

This article from Chief Investment Officer highlights the main concern for pension fund managers: the accommodative monetary policy environment, an issue they believe (or at least the article posits) is distorting the market. One argument in the article states that interest rates are at “crisis levels” despite there no longer being a global economic crisis; however, that is only looking at one side of the coin. While it is true that the global economy isn’t in the depths of a recession, inflation certainly isn’t in a position where central banks are worried about missing their target of price stability. So while absolute valuations for both equities and bonds are stretched by historical standards, and it is noted in the article that, “the downside risk at this point for many asset classes is greater than the upside risk,” this has been the state of the investment environment for the last three to five years, and it’s by no means a new phenomenon.

Another old adage is that the statement “this time is different” holds the four most dangerous words in investing. However, the reality is that every time is always slightly different because markets are adaptive environments. While financial markets are populated by human beings that have behavioural biases that will cause them to act irrationally at times, you can’t rule out the fact that markets themselves are adaptive organisms that respond to historical events. So, as a pension manager or a “perma-bear” pundit who are effectively tilting at the windmills of the Federal Reserve, would you rather stand by your convictions and give up the potential of future financial market gains, or adapt to the current investment environment? Being early is the same thing as being wrong, and the potential opportunity cost of missed gains could outweigh the losses saved by having a bearish stance – it all depends on the length of time until the inevitable forecast is proven right. Interest rates might continue their long-term trend of moving lower, or they might not. Inflation may pick up after years of dormancy, or it may not.

As an investment manager, how do you respond to an environment that has evolved to a point where you are pessimistic about the future but don’t want to get stuck in the trap of trying to forecast when this inflection point will materialize? We would opine that the required strategy is two-fold: proactive portfolio construction and reactive systematic rules. Proactive portfolio construction allows you to “weather-proof” your portfolio so that certain elements will benefit when your forecast comes to fruition, while continuing to stay invested in the market and participate in any future gains that materialize. Reactive systematic rules allow you to fight your behavioural biases and specify how and when to get extra defensive once there is confirmation an inflection point is underway.

While many pundits are quick to blame central banks for a liquidity-fueled rally that is lifting all assets higher, adaptation can be your friend and save you from tilting at windmills..