Since the global financial crisis, capital markets have experienced unprecedented injections of liquidity through massive asset-buying programmes implemented by developed market central banks, which ‘created’ money to make these purchases.
This has entailed an unprecedented expansion of central bank balance sheets.
This increase in the size of global central bank balance sheets appears to have a close relationship with the price appreciation of both equities and government bonds, as well as several other assets.
The combination of quantitative easing and low interest rates has kept yields on short-maturity assets low or negative, despite an apparently strong economic backdrop.
This has supported the performance of many asset classes (such as “junk” corporate debt) and put many investors on the well-documented ‘search for yield’.
These programmes are now beginning to unwind, and the liquidity taps are closing.
The US Federal Reserve is now ‘rolling off’ its balance sheet by allowing for the bonds it has bought to mature. Before this ‘roll-off’, the proceeds of a maturity would have been reinvested in the bond market to keep the balance sheet level constant. These dollars will now simply be cancelled.
The European Central Bank is also currently tapering its bond-buying, with a plan to end it in December and it looks probable the Bank of Japan will follow suit.
We worry that financial markets may be ill-prepared for this enormous change, with investors focusing on the likelihood government bond yields will rise but failing to address broader ramifications, including:
- A return of the attractiveness of cash – the long-forgotten asset class.
- A fall in the power of diversification which could result in investors simultaneously losing money on their equity and bond holdings.
- A broader withdrawal of liquidity resulting in volatility – as a consequence of the herd mentality of investors piling into popular trades, following the global financial crisis. History has shown this can result in significant price moves with little or no obvious fundamental rationale.
We believe investors would be wise to consider carefully how these potential effects could impact their portfolios, beyond a simple market retreat, and to prepare their investment portfolios for the risk of ongoing liquidity shocks.
As a multi-asset fund manager there are a number of tactics which we, and other managers, employ within our investment process.
In the current environment we believe there are three key levers which investors ought to consider when it comes to the construction of investment portfolios.
Firstly, I would highlight the importance of individual bottom-up asset selection. The selection of individual bonds, equities and currencies based on the attractiveness of their yield, sustainability of income streams and potential for capital appreciation.
This active selection of assets can result in a more robust set of holdings with differentiated attributes to the broader market. In this environment we also believe actively limiting exposure to less-liquid securities is sensible.
Secondly, the benefits of diversifying investment portfolios – not by traditional asset class labels, but considering the behaviour of individual assets and how they work together in an overall investment portfolio.
For example, we classify lower-rated corporate debt as representing the same sort of risk as equities.
Finally, taking an active approach to managing drawdown risk by assessing the market environment and event risks (this might include monitoring measures of market sentiment and momentum) and hedging the portfolio accordingly, to aid a smooth investment journey as the actions of the world’s central banks become less investor friendly.