The View from Basel

Over the weekend, the Bank of International Settlements released its annual report on the state of the global financial system.   Several points made in the report match our observations:

The world’s major economies need to curb their reliance on debt.  Debt-fueled growth is ultimately unsustainable, and we need to pursue supply-side policies that encourage productivity.

Low interest rates and quantitative easing are distorting investment decisions and encouraging overconfident risk-taking.  The sooner monetary policy normalizes, the better.

Last year’s BIS report stated that loose monetary policies were inflating financial asset prices while providing little benefit to the economy. They’ve reiterated that view.  Yet, the Yellen Fed is proving to be more dovish than Bernanke’s.  Remember last May when he said to expect QE to be done at 7.0% unemployment and interest rate normalization to begin at 6.5% unemployment?  We’re now at 6.3% unemployment.  QE, while tapering, is still on, and Yellen has guided to no rate increase for an extended period of time.

That leaves investors with a challenge.  How to deploy capital when overall valuations are not cheap and supported by monetary policy that will eventually turn?  Paying attention to valuation helps.  Although the market as a whole appears fully valued (and risky stocks overvalued), large capitalization stocks with high/stable profit margins and low indebtedness still trade at a discount to their historical valuations. They present positive return potential while bearing less risk than the overall market to the eventual normalization of central bank policies.  Having some dry powder for the return of more normal volatility helps as well.

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