By Jason Borbora, Assistant Portfolio Manager, Multi-Asset
Central banks open the liquidity taps
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. Since 2007, for example, the US Federal Reserve (the Fed) has now expanded the ‘asset’ side of its balance sheet from nearly US$1 trillion to around US$4 trillion, through the purchase of government securities using newly created money (Figure 1).
Figure 1: Growth in Central Bank balance sheets since 2007 (US$)
Source: Bloomberg as at 30.06.18
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 (Figure 2) 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 and put many investors on the well documented ‘search for yield’.
Figure 2: Correlation of central bank buying and asset price appreciation
Source: Bloomberg as at 30.06.18.
But now the taps are starting to close
These programmes are now beginning to unwind, and the liquidity taps are closing. The Fed is now ‘rolling off’ its balance sheet by allowing for the bonds it has bought to mature (currently by up to a maximum of US$40 billion per month which increases to US$50 billion per month in Q4 2018). Before this ‘roll-off’, the proceeds of a maturity would have been reinvested in the bond market to keep the balance sheet level constant. These dollars will now simply be cancelled. The European Central Bank is also currently tapering its bond-buying, with a plan to end it in December. Our analysts believe that the Bank of Japan (against a background of tight labour markets and somewhat improved inflation data) is similarly considering an exit from this sort of monetary stimulus.
Figure 3. US Federal Reserve balance sheet (US$)
Bloomberg as at 30.06.18
Are market participants prepared?
We worry that financial markets may be ill-prepared for this enormous change. Investors tend to focus on how a reversal of quantitative easing must lead to rising government bond yields (falling prices) as the supply/demand dynamic suddenly reverses. We think a singular focus on this dynamic and its effects on yields and prices is a limited view. It does not take full account of the potential ramifications, including:
- the attractiveness of cash
- a fall in the power of diversification
- a broader withdrawal of liquidity results in volatility.
Cash becomes attractive again
For the first time in nearly a decade, cash rates have begun to look attractive, with 3-month lending rates offering a greater yield than the US equity market. As the Fed runs down the asset side of its balance sheet, the ‘reserves’ available to the US banking system (which sit on the liability side) will reduce in lock step, draining liquidity from the financial system. It is difficult to know at which point the resulting scarcity of access to money for the banking system might become too much, but if it does, this would put upward pressure on short-term interest rates to increase a willingness to lend. An increase in short-term interest rates marks a relative return of attractiveness for a long-forgotten asset class – cash.
Simple diversification may not be enough
In an environment of rising cash rates, the correlation (a measure of the degree to which the returns on assets appear to move in the same direction) between government bonds and equities increases. Investors who rely on ‘naïve’ concepts of diversification could then lose money on their equity and bond holdings simultaneously (Figure 4).
Figure 4: Correlation between US Treasuries and the S&P 500, compared to cash rates
Source: Bloomberg as at 30.06.18.
Liquidity evaporates, increasing volatility
Liquidity appears to evaporate at times of even limited market stress, perhaps because of the tendency of investors to ‘herd’ into popular trades since the financial crisis. This has resulted in significant price moves with little or no obvious fundamental rationale.
One such recent event occurred in February this year when the enormous ‘inverse VIX product’ universe imploded. These were exchange-traded products where investors speculated on equity markets continuing to display low volatility. In just a couple of days the VIX Index (a measure of implied volatility using options data for the S&P 500) increased nearly 300%, despite no material change in the fundamental economic or market backdrop.
Figure 5: S&P VIX index, showing the recent volatility spike
Source: Bloomberg as at 30.06.18
Much speculation has been put forth as to the causes of such ‘flash-crashes’. These include increased electronic intermediation of markets, such as high-frequency trading strategies which provide ample amounts of liquidity under normal market conditions but withdraw in times of stress, to the rise in passive strategies, such as exchange-traded funds (ETFs) or risk-parity funds. The evidence is mixed, but one trend is difficult to dispute – these outsized moves occur against a benign global economic backdrop. During a period of withdrawing liquidity or a recession, they could look significantly worse. Janet Yellen, the previous Fed governor and architect of the balance sheet reduction, asserted that the process of running down the Fed’s balance sheet would be like “watching paint dry”. We think it could be far messier than that.
We believe investors would be wise to consider carefully how these three potential effects could affect their portfolios, beyond a simple market retreat.
Constructing portfolios as liquidity retreats
- Bottom-up selection of individual assets.
- Structural diversification, based on how assets behave, not their labels.
- Robust drawdown management.
1. Bottom-up selection
We do not own passive strategies. In contrast to many funds which invest across asset classes we spend most of our time on 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 results in a more robust set of holdings with differentiated attributes to the broader market. Furthermore, we believe that limiting and indeed scaling back exposure to less-liquid securities, which are vulnerable to elevated volatility (such as high-yield debt or listed ‘alternative’ assets e.g. reinsurance bonds), is sensible in this environment.
2. Structural diversification
The prospect of bond and equity returns moving in the same direction should trouble many investors who own bonds simply to offset potential losses on equities. We believe that investors should rely not on the label of an asset class, but rather on its behaviour. For this reason, we classify lower-rated corporate debt as representing the same sort of risk as equities. Furthermore, we prefer using strategies, such as options (which are currently cheap due to the absence of market volatility – a key input to their pricing), to provide a reliable offset to equity losses in the event of a market downturn, rather than relying on government bonds.
3. Drawdown management
We monitor a series of quantitative metrics (such as unusual market behaviour, investor sentiment and momentum), alongside our own qualitative assessment, to decide whether to de-risk the portfolio. We also monitor potential event risks to determine whether specific hedges should be used to reduce the strategy’s exposure to an uncertain outcome, for example in Figure 6 below, we highlight how the Fund performed as volatility picked up during Q1 2018.
Figure 6: Focusing on limiting downside risks (VIX spike)
Calendar year % returns for the Fund, Index, Income Peer Average and Defensive Peer Average, respectively 2017: 4.82, 13.10, 7.40, 2.73. 2016: 5.92, 16.75, 10.05, 0.31. 2015: 1.97, 0.98, 2.30, 3.61. 2014: 5.32, 1.18, 5.97, 5.25. 2013: 6.19, 20.81, 11.26, 7.15.
Source: Morningstar, 14 March 2018, NAV based, gross of UK basic rate tax (inclusive of all annual management fees but excluding any initial charges), in Pound Sterling. Time period shown is 25 January 2018 - 14 March 2018.
The list of competitors is frequently reviewed and is based on our Multi-Asset team’s analysis of the competitor landscape. The defensive peer group average is based on all multi-asset funds within the IA Targeted Absolute Return sector.
The income peer group average is based on all funds from within the IA mixed Investment 0-35, 20-60, 40-85 shares and specialist sectors which include ‘income’ and/or ‘distribution’ in their fund names and are over £100 million in size.
Investec Diversified Income Fund positioning through this period (25 Jan 2018 – 14 May 2018)
- We sold 15% of equity futures whilst retaining upside participation through call options.
- Underlying equity exposure itself is resilient having a lower beta vs global equities providing outperformance.
- Fund duration is near to the lowest in its history at c1.2 yrs reflecting concerns around inflation dynamics, Yen is the preferred defensive exposure.
- High yield positioning is conservative, with only 0.3% in the lowest quality credits and the lowest overall high yield weight in Fund’s history.
Central banks are currently the largest participant in the bond markets and they are insensitive to price. Understandably, this creates a vastly different backdrop for global capital markets.
As the liquidity mirage evaporates, we believe in focusing on individual asset selection, diversifying portfolios based on asset behaviour, not traditional labels, and taking a sophisticated and energetic approach to managing drawdown risk.
Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income.
Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss.
Derivative counterparty: A counterparty to a derivative transaction may fail to meet its obligations thereby leading to financial loss.
Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses. This may lead to large changes in value and potentially large financial loss.
Developing market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems. These markets carry a higher risk of financial loss than those in countries generally regarded as being more developed. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates and/or inflation rises.
Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. bankruptcy), the owners of their equity rank last in terms of any financial payment from that company.
Government securities exposure: The portfolio may invest more than 35% of its assets in government securities issued or guaranteed by a permitted single state.
Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates and/or inflation rises.
Past performance is not a reliable indicator of future results and all investments carry the risk of capital loss.
This content is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contains statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual outcomes may differ materially from those stated herein. All rights reserved.
Issued by Investec Asset Management, issued September 2018.