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The Fed According to Velazquez

Friday, September 16, 2016

The US economy remains in reasonably good health, while the global economy is still somewhat fragile. This puts the US Federal Reserve firmly into investors’ focus. But interest rate hikes are a delicate matter that could do more harm than good – depending on the perspective. For Carlo Benetti, Head of Market Research and Business Innovation at GAM, perspective is exactly what counts – changing it can yield surprising insights.

“Las Meninas” is a deceptive painting. The apparent simplicity of the work, a young girl surrounded by her bridesmaids, conceals an enigmatic complexity. The girl portrayed is Margarita Maria, daughter of King Philip IV of Spain, surrounded by "Las Meninas", the bridesmaids. But the painting is not just a portrait of a young girl, as the same image depicts a range of different scenes: the royal couple reflected in the mirror on the wall, the self-portrait of Diego Velázquez, the Spanish painter of the piece, and a dignitary standing in the background. And then there is the picture within the picture: We do not know what Velázquez was painting - he is certainly not working on the portrait of Margarita Maria, because both artist and subject are turned towards us and we see the whole scene except for the front of the canvas. The centre of the painting is neither the girl nor the mirror that reflects the faces of her distinguished parents. The real vanishing point of the painting is the right elbow of the dignitary in the background, in the illuminated doorway.


Diego Velasquez, Las Meninas, 1656

To fully understand the pictorial representation, the observer must reverse his perspective and ideally put himself in the illuminated doorway where the dignitary stands. From that position the whole scene can be observed: the group at the centre, the subject on the artist's canvas, the royals (and us!) on the outside yet "captured" in the image.

To understand what is happening in the financial markets, we need to do something similar: reverse our point of view.

Reverse point of view

At first glance, the scenario is dominated by the ongoing struggle between the forces of reflation and recession – the risks of deceleration in growth in Europe are still on-going and the IMF even speaks about the danger of "stalling". Global growth is hindered by the black heart of debt, which never really disappeared as well as by the demographic dynamics of the advanced economies.

The vanishing point of the economic outlook is still in monetary policy: nine years after the crisis – the longest and deepest since World War II – the central banks are still dictating the pace and cadence of growth in the financial markets. And at the centre of it all, the "right elbow" of the dignitary, is the Federal Reserve.

What will the Fed do?

As GAM’s CEO, Alexander Friedman, wrote in Project Syndicate (The Fed’s risky new mandate): “The Fed is caught between a domestic economy that increasingly demands a return to normality of monetary policy and the vulnerabilities of the global markets, where 60% of transactions are in dollars and which therefore require a continuation of the accommodating approach.”

The Fed, which is saddled with responsibility for the world's financial stability, is opening a whole new chapter and, of course, there are also new risks, as noted in the quoted Friedman article: "If Yellen and the Fed feel bound to the financial markets, the risks of tougher moves on rates will increase the more the Fed is "behind" the inflation curve."

The chorus of those cautioning against haste in the reversal of monetary policy are up against the voices warning of the danger of keeping rates low for too long, and for some time certain members of the Federal Open Market Committee (FOMC) have been warning against the risks of dangerous financial bubbles triggered by a prolonged period of low rates. These are unintended consequences; human actions directed towards a particular purpose can sometimes have other, possibly opposite, effects.

Velasquez Chart

It is impossible to predict the long-term consequences of unprecedented monetary expansion (Source: Thomson Reuters Datastream, ECR)

The Fed is travelling a narrow path: on one side are those calling for a rate hike to bring the economy back to normality, on the other those who underline the fragility of the global environment and the risks of monetary tightening at the wrong time.

“It is better to err on the side of too much stimulus that can be remedied later, if necessary, than risk derailing a recovery with monetary tightening that is then impossible to correct", wrote Andrew Haldane of the Bank of England.

The final cause for reflection on "Las Meninas" relates to the canvas that Velázquez was painting, a painting within a painting, a play of perspectives trapping the observer inside the image. We don't know what the subject of the canvas is, just as we don't know what investment choices will prove the best. The canvas of the "best portfolio" is destined to remain a mystery, and always a function of the circumstances of the present day when investment choices are made.

The truth behind the Velázquez picture is that it's "upside down" and is only completed with the viewer's contribution, the perspective that reciprocates the perspectives of the characters portrayed. A portfolio is more than just the sum of investment instruments - it requires investor participation, and it must be understood that the representation of the economic environment is reversed compared to just a few years ago, that the era of risk-free high yields is over. A new point of view is needed for portfolios too.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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