Diversification, the great free lunch of investing, is often taken for granted by investors. Bonds and equities have acted as effective portfolio diversifiers for much of the new millennium because of their different return and volatility patterns. Two of the three main assets in a typical portfolio, cash being the third, moved in opposite directions during financial crises such as 2001 and 2008.
Indeed, portfolio management has become accustomed to this trend and now treats it as an article of faith. But does this faith represent a dangerous cocktail of overconfidence and extrapolation?
The mantra that monetary policy is driving market returns is well rehearsed. Less obvious is the idea that policy is driving the relationship between bond and equity returns.
This year gave a flavour of things to come: a period of high turbulence in May and June as markets took on board the possibility the global liquidity flood was about to abate. Bonds fell sharply and equities stumbled as investors fretted about an end to the Federal Reserve’s emergency asset-buying. Price volatility rose in both mainstream asset classes. Using US equities and 10-year bonds as proxies, the correlation was negative from 2009 to the middle of this year and positive thereafter.
Shock absorbers
Next year could mark a turning point as policy makers exiting the triage phase of recovery from the Great Financial Crisis move away from a material reliance on monetary activism into the potentially more volatile territory of forward guidance.
What does this mean for fixed income? Suppose there is one dominant, price-insensitive buyer (the Fed). Now suppose this buyer has a progressively smaller wallet. All other things being equal, the volatility of prices rises as buyer and seller strive to match each other. Add in another group of (reasonably) price-insensitive buyers (China and the like) downsizing their spending due to slowing growth in foreign exchange reserves, and this risk expands.
Of course, there are shock absorbers. First, the developed world’s ageing populations and their agents (think insurers) have a structural bid for yield. Second, the Bank of Japan is expanding its monetary easing . Some of governor Haruhiko Kuroda’s largesse eventually will pass through Narita Airport as growing shortages of domestic bonds force local institutions to shake off some of their home bias. The conclusion? Do not expect a fixed income bloodbath in 2014 – but brace for more volatile returns.
How about equities? 2013 will probably be known as the Year of Equity. The problem: the numerator of the price to earnings ratio (price) has been driving returns in most markets this year, rather than the denominator (earnings). Higher pricing of the final claim on corporate cash flows – equity – has been aided by the tightest debt spreads on record, insatiable demand from yield-hungry investors, and the ability to refinance and extend fixed obligations at low cost. This works well for a while, but at some point earnings need to come through.
Theory has it the discount rate partially connects bonds (fixed coupons discounted by an interest rate) and equities (fluctuating cash flows discounted by this interest rate plus some variable risk premia). Here is the rub: arithmetically, the lower the real interest rate, the greater the volatility triggered by small changes. If the major driver of returns (policy) becomes more volatile, so do the assets that have benefited from that support.
QE tide turns
Clearly the unprecedented monetary stimulus tide will not last forever. When it dwindles, what will become an effective diversifier of portfolio risk? Bonds or equities? Not entirely; see the drawbacks described above. Cash? Perhaps, but if rates rise for longer-dated bonds and remain anchored by policy for short-dated issues, the diversification benefit of a near zero return is limited.
Challenging the assumptions of the past at a time of regime change is vital in financial markets. This means rethinking fixed income to seek out relative value between bonds, capitalising on rises in volatility and harvesting risk premia. In other words, taking an unconstrained approach. It means a focus on alternative strategies that do not start with the discount rate. Examples are infrastructure and real estate debt, opportunistic acquisition of long duration assets chased off bank balance sheets by regulation and market neutral long-short strategies.
Any reversal in the policy tide involves uncharted territory. A reversal in the 30-year downward trend of rates must, however, involve some different results. 2014 may very well become known as the year in which unwary investors ask: “Who stole my diversifier?”
Source: http://www.ft.com/intl/cms/s/0/0687562c-5e7f-11e3-8621-00144feabdc0.html#axzz2nwa2gnpW
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