Updated: Mar 17
Economies that are either growing too fast or growing too slow present potential risks and opportunities for investment portfolio management. There are key indicators that tell us which of these extreme economic conditions is in play. Also, when these conditions exist, it is safe to expect responses from the monetary and in some cases, the fiscal authorities.
Generally, active portfolio management requires forecasting monetary and fiscal policy actions in the light of prevailing economic conditions. On the other hand, passive portfolio management entails waiting for the policy responses before taking investment actions. There is a range of responses that monetary authorities can deploy to check extreme economic conditions from contractionary to expansionary policies.
Contractionary policies are pushed out by monetary authorities when inflation is higher than expected. Reserve requirements are also enforced by authorities to control inflation. When the inflation rate in a country is higher than normal, this is an indication that the economy is growing too fast and is known in the investment world as "overheating".
This happens when supply is unable to keep up with demand due to capacity limit constraints on the side of the suppliers and this generally leads to a rise in prices of goods and services. The expected response from the monetary authorities would be to push interest rates up so as to tame demand and encourage more savings.
There are massive selloffs by active investors in the bond and equity markets because holding cash becomes more attractive. it is also advisable to hold cash because when the interest rates eventually move up, assets prices are expected to get depressed and opens up windows of opportunity for investors holding cash.
Active-Investors who bought long-term bonds with relatively lower yields will, in anticipation of cheaper bonds, liquidate their positions before the monetary authorities take any action. When interest rates eventually trend higher, the values of existing bonds become lower and yields of existing bonds become relatively lower and less attractive when compared to newer bond issues that come with higher yields to keep up with the hiked interest rates.
In the equity market, investors expecting interest rates to rise will pull out from the equity market as less risky investments such as bonds and T-bills which offer higher yields, as highlighted above, become attractive.
Equity prices may be overpriced and short-term traders would go on profit-taking runs via the selling of stocks so as to be ready to move in on opportunities created by depressed markets. Similarly, active investors in currency markets may sell off foreign currencies in exchange for local currencies. This is because higher interest rates will attract foreign investors and the demand for local currencies will go up, thereby leading to a stronger local currency.
Overall, timely investment decisions are important else, portfolio value may depreciate if investment actions arent taken before the interest rate hike. This was evident in December 2021 when the Fed pivoted from a long-held position about the high inflation rate. The US was experiencing a high inflation rate which was caused by a combination of excess liquidity and supply chain bottlenecks.
The Fed had consistently stated that the high rate of inflation was transitionary and mainly caused by global supply chain hurdles. The Fed eventually backpedaled in December 2021 and this caused massive selloffs in all markets e.g stock bonds and even bitcoins.
Expansionary monetary policies become necessary when there is a slowdown in the economy or when the economy is in recession. Technically a country is in recession when it sees two consecutive negative quarterly economic growth rates.
For example, a lot of countries went into recession during the covid-19 pandemic due to the collapse of several industries occasioned by low demand for goods and services. In addition, there were severe restrictions and lockdowns which caused a downturn in economic activities. Most financial markets are also affected as prices tumbled due to low demand at the time.
Generally, when an economy is in recession, demand is generally low and prices of bonds and equities are depressed. The monetary policies would roll out a plethora of tools to get the economy back on the path of a sustainable growth rate. Active traders would consider rebalancing their investments and would tilt their portfolio towards equities and bonds, particularly for sectors that are expected to bounce back on the back of such expansionary policy actions.
The primary policy would be to bring down interest rates so that credit is made available at cheaper rates which in turn is expected to stimulate demand. Also, quantitative easing(QE) may be utilized. QE is when the monetary authorities purchase bonds and assets from the markets and in the process, push more cash into the economy.
Lower interest rates tend to depress local currency value but the economy is expected to benefit because exports will be cheaper. Again, as an active investor, timing is crucial because if the policy actions have already been taken by the authorities, investment opportunities may be lost.
In general, the above investment actions are applicable when the prevailing inflation rate is high compared with expected inflation and the economy is overheated on one hand On the other hand, when the economy is slowing down with the inflation rate either becoming too low or when there is deflation happening. In rare cases, when an economy has both a high inflation rate as well as low economic activities or a recession, a wait-and-see approach is advisable.
In conclusion, active investors ramp up buying and selling activities in periods of extreme economic conditions as there are investment opportunities to cash in on. From an active investor's lens, these opportunities abound either when an economy is heating up or slowing down. active investors position their portfolios right in front of monetary policy action. On the other hand, passive portfolio investments usually play safe and wait for such actions before reacting