By Marino Valensise, Baring Asset Management (Barings), London
(Barings is the Subadviser to the ASTON/Barings International Fund)
We are living in unprecedented times. Interest rates have never been so low for so long, and government bond yields, in developed markets especially, have reached historic lows. These dramatic shifts have led investors to make significant reallocations within their portfolios to make up for the yields they are no longer achieving with bonds.
The single major cause has been “financial repression”, meaning the artificial depression of interest rates by central banks. This eases the debt burden of borrowers (including heavily indebted governments), while penalizing savers, lenders, and those dependent on a fixed-income, such as pensioners. This repression has been achieved through the use of standard monetary policy as well as more extraordinary measures such as quantitative easing. This almost limitless provision of liquidity at increasingly lower interest rates has driven asset prices to levels they would unlikely have achieved otherwise—Eurozone bond yields at all-time lows, equities achieving historic highs, and certain currencies moving dramatically lower.
Heightened Potential Volatility
The question is when will this policy (the proverbial “punch bowl”) be stopped or reversed. If this occurs without careful management by central bankers, we could see overstretched markets snap back, particularly those not supported by economic fundamentals, only by easy monetary policy. Persistent financial repression has driven a large number of investors into riskier markets and, once they reach the point where the marginal buyer disappears, any attempt to sell and take profits may drive down prices violently.
We have most clearly seen an example of this recently with volatility in the German government bond market. Investors using these assets to fund real liabilities will increasingly become sellers, as yields have simply gone too low, or even negative. Market liquidity has deteriorated, thanks to regulatory changes affecting the amount of bank capital available for market-making.
The regulatory framework has also contributed to a reduction in the number of defined-benefit pension schemes, which were a natural long-term buyer in the fixed income markets. This combination of factors will lead to more dramatic falls than the market is used to. Rather than being an anomaly, we think this trend is likely here to stay.
Market volatility has also been exaggerated by the increased leverage assumed by investors. When they can borrow at rates close to zero, why not turbo-charge investments in a market which the central bank has more or less explicitly underwritten? Of course, the downside is that when the market turns and these players start running for the exit, the consequences of such a rush will be dire in terms of volatility.
So what does this mean for multi asset investment? One consequence of the market developments I have described is that the bond and equity markets have become far more correlated than in the past. If bond yields go up, meaning a capital loss for bonds, the equity risk premium becomes less attractive and, thus, equities might also sell-off. Once considered a “safe haven” bonds will be increasingly correlated with risk assets.
Global markets have become monetary policy addicts, and as the day draws closer when the punch bowl will be taken away (i.e. the next probable move by the US Federal Reserve) we are starting to see more and more upheaval. While this volatility may constitute an uncomfortable new reality for investors, I am hopeful it may also signal our first steps back to a more normal world, one we haven’t seen for nearly a decade, in which assets are linked to their true and intrinsic value.
The information contained in this article is provided by Baring Asset Management (“Barings”), a subadviser engaged by Aston Asset Management, LLC (“Aston”). Barings is not an affiliate of Aston and their views do not necessarily reflect those of Aston.
This material is not intended to be a forecast of future events, does not constitute investment advice, and is not intended as a recommendation to buy or sell any security. Investors should consult their investment professional regarding their individual investment program. Since the date of this report, economic factors, market conditions and Barings’ views of the prospects of any particular investment may have changed. Investors should consider the investment objectives, risks and associated costs carefully before investing. Forward-looking information is subject to certain risk, trends, and uncertainties that could cause actual results to differ materially from those predicted. Past performance is no guarantee of future results.