Taking stock of safe and risky assets

While the investment industry dedicates huge amounts of resources to analysing 0.25 per cent changes in policy rates and whether or not the word “considerable” crops up in the minutes of the Federal Reserve, views on long-term structural trends and potential turning points are often left to subconscious rules of thumb that can reveal behavioural biases and other inconsistencies.

Last month’s policy announcement from the Bank of England is therefore far less important with regards to the change in the interest rate itself than in what else it can tell us about the prevailing policy mind-set, and how this interacts with market perceptions of risk.

Bank of England policy: More of the same, or a sign of transition?

Since the financial crisis, policy makers in most major economies have responded to weak growth with ever lower rates or further bond buying. This course of action has contributed to the strong performance of bonds, or bond-like assets – and has influenced investor perceptions of their “safe-haven” qualities. 

As the Bank of England chose to lower rates, last month’s action could be seen as more of the same. But this would be to ignore the broader context, the other actions announced, and the language of Mark Carney.

It is not a new argument that cutting interest rates appears to have become less and less effective in boosting growth, but other actions taken by the Bank of England last month suggest that they acknowledge that something new is required. 

In this regard the cut in base rates and the new QE programme may be a sideshow, while the new Term Funding Scheme (TFS) could be extremely important. TFS represents an explicit attempt to ensure that policy actions translate to real effects on households and companies.

A shift in the policy stance in the UK and around the world could be very meaningful. It could challenge those rules of thumb about which assets are safe and which are risky, how to add diversification to a portfolio, and what exactly it is we mean when we say an asset is “cheap” or “expensive”.

Interest rates and investor experience

The past matters in financial markets: investors fall in and out of love with assets based on past returns, risk models look at past behaviour and predict what will be risky or safe in the future, regulators fight yesterday’s battles.

It is no surprise then that, given the experience of the last 30 years, fixed-income assets are considered “safe” and equity assets “risky”. Not only have fixed-income assets shown themselves to be safe while generating returns that one would normally associate with growth assets, but the experiences of the tech bubble and financial crisis mean that demand for protection against drawdown is arguably higher than ever.

When investors talk of safe assets, they therefore generally mean bunds, treasuries, gilts, JGBs and other government bonds issued by large developed economies. In one sense, they actually are “safe” assets. They are typically negatively correlated with risk assets. More specifically, if the risk of recession is perceived to be rising, “safe” assets rally. That’s a good reason for a zero-term premium – why should you get paid to insure against recession?

Of course, for serious, long-term investors – Buffett, Soros and anyone else with a long memory, penetrating ideas and a proper time horizon – these are not really safe assets today. First of all, they are priced to deliver negative real returns, and the skew on the return distribution is all to the downside. The best an investor can hope for is to lose a little, unless they can sell to someone else at a higher price before the bond matures.

However, should this paradigm change, what looks like safe assets today could be highly vulnerable. Changing approaches at central banks such as  the Bank of England could be a part of this paradigm shift; or perhaps all that is required is a change in investor sentiment. Our experience is that it doesn’t take a specific catalyst for investors to shift from being comfortable with low volatility to a fear of missing out. As the cost of holding cash and mainstream government bonds becomes ever more punitive, this shift in outlook arguably becomes more likely.

Interest rates, diversification, and correlation

Correlation patterns between assets are not static. The chart below shows rolling correlation between the FTSE 100 and UK Gilts. It shows that for much of the new millennium, holding a mixture of equity and government bonds has helped to reduce volatility.

Many of us have a subconscious belief that a negative bond/equity correlation is to be expected. Weaker growth harms equities, but helps bonds because interest rates fall.  However, the 1990s show that such patterns are not to be relied upon if you are looking to add diversification to a portfolio. Looking ahead, if policy makers and markets decide that lowering interest rates is no longer effective in stimulating growth, or if we simply take the view that there must be some lower bound for interest rates, then it would be dangerous to place too much faith in recent history repeating itself.

Interest rates, asset valuation, and mean reversion 

Today there appears to be an inconsistency of view between arguments that equities are expensive relative to their own history while bonds represent a “safety” asset despite in many cases being at all-time lows in yield. The reality is that such arguments are often driven by subconscious beliefs which in turn are the result of experience.

Valuation is always conditional. Most valuation techniques rely on some implicit belief in mean reversion, but this is only relevant if you think that history always bears some resemblance to the future. In the case of government bond yields, it has been extremely dangerous to bet on mean reversion over the last 30 years. Anyone who has argued that since the financial crisis bonds are expensive based on past average yields has been made to look foolish because the period has marked a transition from one regime to another.

Analysing the Bank of England’s announcement last month is only of use insofar as it can tell us anything about whether we are about to enter another transitional phase.

Eric Lonergan, macro fund manager, M&G Investments