Monday, May 16, 2011


Lately I’ve been reading a lot about sequencing. The term is used in reference to how the Federal Reserve might go about communicating and then changing current monetary policy. The sequencing might go something like this: 1) The Fed ends quantitative easing as scheduled by the end of June but announces that it will continue to reinvest maturing bonds in U.S. Treasury securities, thereby keeping its balance sheet from shrinking, 2) Two months later the Fed announces that it will no longer reinvest bond proceeds and allow its balance sheet to gradually shrink, 3) Two months later the Fed changes the language in its monthly statement so that it no longer implies short-term interest rates won’t change in the foreseeable future, and 4) Sometime in the first quarter of 2012 the Fed raises short-term interest rates for the first of many increases to occur during the year. Of course, no one really knows if this sequence is correct and we suspect that the Fed, like everyone else, will react to economic data as it develops.

We have been having our own discussions about sequencing in the investment team over the past few weeks. Recent events have us pondering the possibility that the economy will slow to the point that it will impact risk markets. The signs are there if you care to see them. They include the commodities market imploding last week, bonds rallying, QE2 inexorably ending in June and market participants wondering if the risk markets are beginning to price this into current prices, the Arab “spring” beginning to look a little “chilly,” the dollar showing signs of rallying, unemployment claims spiking up again recently, and leading economic indicators showing signs of slowing. All of the above may be nothing more than the “wall of worry” that bull markets always climb. After all, earnings continue to come roaring in and this quarter looks like another slam dunk for corporate America. But still…we’ve been thinking about how we might take risk off if necessary.

The sequencing might go something like this. First we are selling our Germany ETF in DA and DUA portfolios and preparing to sell our commodity futures position in all portfolios as soon as this week. Next we rotate to more defensive industries within our cyclical sectors like Energy, Tech, Consumer Discretionary, etc. Next we rotate from cyclicals to defensive sectors like Health Care, Staples, and Utilities. Finally we rotate from defensive equity sectors to cash. A similar sequencing will occur in the fixed income allocations of our portfolios but we haven’t really focused on those discussions just yet. Sequencing seems to be the name of the game of late.