Grillo’s corner: The four horsemen

The views expressed represent the Manager's assessment of the market environment as of Dec. 15, 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

I have tried desperately to remove my gray-colored glasses, but they will not come off. As we head into 2015, I find myself worrying about four topics that are upsetting capital markets in late 2014 and will likely continue to do so in 2015. I am calling them “The Four Horsemen.” Unlike the biblical prophecy, they are not foretelling financial apocalypse, but they could definitely upset the usual Wall Street forecasts of stronger growth on the horizon and benign capital markets. Let us delve into these conditions.

Divergent central bank policy

It is widely known that the U.S. Federal Reserve and the Bank of England have halted significant monetary stimulus, and perhaps will be embarking on a small tightening of monetary conditions. The two banks may increase short-term rates in reaction to improvements in each country’s economic scene. However, other world central banks are still engaging in unorthodox monetary stimulus and deciding if they should do more. The introduction of these divergent paths (see Chart 1) has caused volatility in the capital and commodity markets, and we believe it will continue to do so. Capital markets have received significant support from money-printing exercises, and they are now confused about future support for these activities.

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Grillo's corner: The four horsemen

Chart 1: Central banks have used extraordinary monetary policy in this levered environment

Chart 1: Central banks have used extraordinary monetary policy in this levered environment

Source: Bianco Research, December 2014.

Already, the introduction of these divergent paths is roiling the currency markets. Monetary policy of incremental tightening can contrast markedly with central banks that are practicing unorthodox policies that are not rules-driven. Currency markets react to the uncertain contrasts with significant price moves. The U.S. Dollar has increased in value by more than 10% versus major world currencies in 2014 (as measured by the U.S. Dollar Index). It has appreciated by more than 11% versus the world's emerging market currencies (see Chart 2).

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Grillo's corner: The four horsemen

Chart 2: Emerging market currencies have declined significantly as the U.S. dollar has risen in 2014.

Chart 2: Emerging market currencies have declined significantly as the U.S. dollar has risen in 2014

Source: Bloomberg, December 2014.

The J.P. Morgan Emerging Markets Currency Index measures the value of a basket of emerging market currencies versus the U.S. dollar. The index goes up when the basket gains strength, or value, compared to the dollar.

Indices are unmanaged and one cannot invest directly in an index.

The Bank for International Settlements recently warned about the currency exchange mismatch that may result from the significant dollar issuance that has taken place in the corporate emerging markets sector. Additionally, oil-producing countries are having a tough time as revenues decline and they are faced with servicing liabilities denominated in a more expensive U.S. dollar.

Deflationary forces

Despite the better than $10 trillion (U.S. dollar equivalent) money-printing exercise that we have seen from the major central banks in the last six years, price levels have been enormously stubborn in reacting to this policy. We have seen the credit transmission mechanism as broken in the age of macroprudential actions. The implementation of this macroprudential policy has effectively limited the expansion of finance company balance sheets, and in many cases, has decreased them. These policies should have been in place while the global system was adding leverage in the 1990s and the 2000s, but central bankers and other regulatory bodies were blind to the dangers. We now have an environment where the correlation between easy money conditions and inflation has dissolved (see Chart 3). The only inflation that we are getting from unorthodox monetary policy is asset price inflation.

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Grillo's corner: The four horsemen

Chart 3: The correlation between easy money and inflation has dissolved.

Chart 3: The correlation between easy money and inflation has dissolved.

United States

Source: Bianco Research, December 2014.

M2 is a measure of money supply that includes cash, checking and savings deposits, money market mutual funds, and other time deposits.

The U.S. Consumer Price Index (CPI) is a measure of inflation that is calculated by the U.S. Department of Labor, representing changes in prices of all goods and services purchased for consumption by urban households.

Euro area

Source: Bianco Research, December 2014.

M3 is a measure of money supply that includes M2 (defined above) as well as large time deposits, institutional money market funds, short-term repurchase agreements, and other larger liquid assets.

The Harmonized Index of Consumer Prices (HICP) reflects changes in prices of goods and services consumed by households across the euro zone.


Source: Bianco Research, December 2014.

The Japan Consumer Price Index tracks fluctuations in prices of goods and services consumed by Japanese households across the country.

The State Street PriceStats series (an inflation measure published by State Street Corporation) is showing the deterioration on general pricing power in the U.S. (see Chart 4). The PriceStats product surveys internet prices en masse, and usually leads price trends that show up in the government price series. The trend toward disinflation/deflation is also being observed in Europe. With a continued trend toward deflation, the Federal Reserve could be reluctant to engage in further monetary tightening.

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Grillo's corner: The four horsemen

Chart 4: Pricing power in the U.S. has deteriorated.

Chart 4: Pricing power in the U.S. has deteriorated

Source: State Street, PriceStats, December 2014.

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Grillo's corner: The four horsemen

Chart 5: Dealer holdings of domestic bonds currently a fraction of those of buy-side firms

Low liquidity environment

My colleagues have done a nice job of highlighting the current environment of low bond market liquidity . This phenomenon is also a product of macroprudential policy and its effects on bank balance sheets. Dealer inventories have decreased as banks have made tough choices on where to deploy their capital and/or use risk-based capital credits that are counted toward regulatory thresholds. They are also concerned with total balance sheet size, as they are penalized for operating as so-called “too big to fail” or systemically important financial institutions (SIFIs).

As shown in Chart 5, investment dealer bond inventories now make up a precariously low percentage of total bond fund assets. With reduced balance sheet allocations, the dealer community is often forced to cross bonds to other buyers, rather than buying and positioning them. This becomes a compounding problem as multiple customers often place liquidation orders at the same time. Investment managers would be prudent to operate with an enhanced liquidity component in their portfolios. Additionally, market events could be met with outsized price moves as equilibrium levels will take longer to work out.

Chart 5: Dealer holdings of domestic bonds currently a fraction of those of buy-side firms

Source: Federal Reserve Bank of New York, Securities Industry and Financial Markets Association (SIFMA), and Investment Company Institute (ICI)

China economic transition

China has seen explosive growth during the past two decades. The surge in growth has been fueled by an import-raw-goods / export-finished-goods machine that has made use of relatively cheap Chinese labor markets. China’s growth also benefited from an enormous investment in residential and commercial real estate. Additionally, useful and non-useful (vanity) infrastructure projects blossomed as provincial managers competed for favor with the central communist party elites. Chinese gross domestic product elements are much more heavily tilted toward capital investment, and less so toward consumption.

As China was confronted with the 2008-2009 global financial crisis, it attempted to help its population cope by loosening monetary standards, and it fuelled a near-term debt boom that now has the capacity to inflict a significant hangover. The Chinese have responded by introducing a temporary tighter monetary regime (which they are tweaking as growth weakens). They are also introducing macroprudential measures to cool property markets. Finally, President Xi Jinping has embarked upon a major crackdown on business corruption within Chinese society. All of these measures are needed in order to deal with hugely imbalanced growth. The big danger is that the transition will be messy and result in economic and financial weakness. Market participants are left to sift through anecdotal economic readings to gauge this transition as Chinese government statistics are thought to be manipulated. This has led to China’s data releases being seen as unreliable and many corporations have altered their positioning to reflect a more constrained growth outlook.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.


Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

Charts shown throughout are for illustrative purposes only and not meant to predict actual results.


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