If investors faced a difficult investment environment before Brexit, the challenges they now face have intensified. We believe a UK recession is nearly unavoidable, the “Japanisation” of Europe is increasingly likely and we think central banks will be more cautious on both sides of the Atlantic.
It is our opinion that central bank action will continue to dominate – for example, the Bank of England has already signalled further quantitative easing and rate cuts are imminent. Meanwhile, in Europe the ECB will increase both the duration and scope of its asset purchase programme as the pool of available securities continues to shrink. There is now only a minor chance, in our view, of a US rate hike in July and the Fed is likely to tread a more cautious path, holding rates until next year.
While this makes the search for yield increasingly challenging, pushing investors to take more risk, there is a concurrent increase in tail risk driven by lower liquidity, slower growth, policy noise and heightened uncertainty. Further QE could also undermine the credibility of central banks if it fails, proves politically divisive in Europe or creates inflationary pressure in the US.
No hiding place in fixed income
In today’s new reality, we believe fixed income is no longer a safe hiding place – yields are increasingly negative, diversification is gone and liquidity is fractured.
Market risk has increased as yields fall further into negative territory, a trend that has been developing rapidly in recent months. Around US$10tn in government and corporate bonds are now yielding less than zero. Investors have to take on increasing duration risk to potentially achieve positive yields – over 50 years in the case of Swiss sovereign bonds. With correlations between bonds and equity also in positive territory, bonds can actually amplify, rather than diversify, risk in portfolios.
Fractured liquidity also adds a growing risk element to portfolios and will most likely only worsen going forward. Central banks may be accumulating even more of the available free float, damaging liquidity. Dealer inventories, which have collapsed since pre-crisis levels, may also come under growing pressure from regulations, especially as Basel III will be fully implemented over the next three years. Fractured liquidity reduces the market’s ability to provide fundability between cash and bonds. Investors will be less confident of their ability to exit positions and may pay increasingly high costs to do so.
The prudent search for yield
In the context of disinflation, low growth and the search for yield, we think it is increasingly important not to fight the central banks. Investors have no influence on the direction of regulation, which continues to tighten, on the quality of communication or the policy objective function of certain central banks. “We strongly believe portfolio construction is the best tool available to investors to adapt to the new reality and prudence is the name of the game – building ‘buy and maintain’ safer portfolios that trade less, reduce duration risk and limit access to poor liquidity instruments, and create additional diversification.”
In fixed income markets, the status quo is for market-capitalisation-weighted portfolios, which, by design, reward leverage. This model won’t provide a safe haven for investors in our opinion. It leaves them increasingly exposed because fractured liquidity implies more frequent liquidity-based accidents in the foreseeable future and during those events, we believe investors will find exiting positions both more difficult and more costly.
“Therefore, rather than mitigating liquidity risk, we believe investors should focus on fundamentals and bring default risk mitigation to the heart of portfolio construction in their efforts to reap additional yield to meet return targets.”
Investors could also consider moving away from using risk and return as their key metrics. Liquidity and yield are both critical issues. Investors ought to consider outcome-based methods that maximise the return for a given level of risk, but also consider the sources and the liquidity profiles of those returns. Importantly, when liquidity is expensive, diversifying across assets of varying liquidity profiles improves the scope for capital preservation and the ability of the portfolio to cover unexpected liquidity needs, for example.
The prudent search for yield also implies looking for bond-like substitutes and in this regard, multi-asset portfolios built on risk-based portfolio construction with a strong focus on drawdown management can bring a lot to the table. These portfolios address many of the key issues in fixed income markets by providing maximum diversification of both traditional and alternative risk premia, reduced sensitivity to interest rate movements and liquid, transparent and scalable implementation.
In today’s new reality where fixed income portfolios no longer fulfil the same role they once did, investors may want to consider what alternatives are available to provide shelter from growing market risk, lack of diversification and fractured liquidity. We believe the best tool for adaptation is a more prudent approach to portfolio construction that puts fundamentals and liquidity risk front and centre.
