This century started with individual sub-prime borrowers having debt problems, escalating in serious issues for financial institutions later on. These problems caused the economic and government debt crisis in a subsequent phase. Each of these steps came with global market drops and volatility. The problems were each time ‘resolved’ by ever bigger institutions, facing problems afterwards. Finally government debt problems were ‘resolved’ by the central banks without any big troubles… up until now.
Flood of liquidity
Central banks have created a tsunami of liquidity with asset purchases and near zero rates all over the developed world. Unorthodox monetary policies of this size have never been explored before. The US Federal Reserve balance sheet grew from less than $1trn (€776bn) up to more than $4trn today, and outstanding debt in Europe is higher now than it was before the euro crisis.
While the Fed started the tapering of its stimulus as of January, Mario Draghi just announced fresh aid of hundreds of billions of euros. These measures altogether were taken in the attempt to stimulate the economy and to re-establish growth. The encouragement for risk-taking resulted in the current situation of stock and bond markets at all-time highs and stress indicators like Vix near pre-crisis levels. Risk tolerance has returned to the market. Financial stability might seem to have returned, but volatility and a new crisis are just around the corner.
Disaster waiting to happen
The exact timing and strength of earthquakes are difficult to predict, and so are the trigger and scale of the next financial crisis. As an investor, one should be aware of the current market conditions and shuffle portfolio allocations to prepare for possible risk scenarios. Knowing that global fixed income portfolios rose for 30 years and yields came down from the ’80s through to today, should ring some bells. ‘Should’ is the right word, as even in the mutual fund environment you might cross those who do not think ahead. Examples are funds managed mainly based on statistical data and back-testing. As global bonds markets have built quite a good risk-return profile in their 30-year uptrend, these historical data might miss some reality awareness of the current market condition. Risk-return pairs can and will change.
Who’s buying these bonds?
The intelligent investor should make some risk-return calculations and add some thoughts about current yields. Yields of peripheral euro countries have dropped dramatically. Today countries such as Spain and Italy can borrow money at rates below those of the US. Even more astonishing is Ireland, with current yields of 10-year bonds around 1.7% borrowing at lower costs than the UK (2.5%). If you remember the crisis which Ireland has gone through recently (with yields of 10-year bonds peaking at 14% in 2011), you can ask yourself who is lending them money at this rate. The aggressive search for yield has come to a point that nearly no reward is given for the interest risk one takes. Why should one take the ‘opportunity’ of having less than 1.5% yield to maturity on a global bond portfolio with quite a good chance of having a drop of 10% or more within some years. A better buying opportunity will be after such a drop, only missing a minor interest rate in between. Investors in US Treasuries and TIPS will fully agree as they remember what a sudden rise of interest rates did to their portfolio holdings in the summer of 2013.
Investors will have a hard time in their attempt to find the best and safest asset allocation for defensive and balanced portfolios. The old theory of investment grade bonds being defensive should be forgotten for a new era in which the correlation of bonds and stocks might be much greater than expected. Market slumps may even be caused by bond markets falling first, contaminating stocks. Financial advisors can try to cope with these issues by protecting clients’ portfolios in different ways and by concentrating on valuations in the selection of assets. Options and futures might be used to hedge for downside risk. Total return funds and index trackers can be replaced by absolute return and long/short funds. Floating and short duration bonds can be bought to address the interest rate risk. Precious metals, commodities and property can be added for their insurance characteristics as these assets are uncorrelated and protect against monetary unorthodoxy.
Last but not least, for investors located in QE-territory, other main currencies of countries with lower or no QE can be added to hedge against currency devaluation of investors’ base currency. While the excessive credit creation inflates assets globally, central bankers should become aware of the game they are playing. The current monetary policies create a substantial risk for universal financial, economic, social and geopolitical unrest. The role of the central banker should be mainly linked to financial stability instead and government debts should be reduced.