After the flight to safety that began last year, the value of a cautious stance may be increasingly eroded as central bank policies such as quantitative easing encourage a return to risk-on trade.
With the recent rounds of quantitative easing (QE) by the Bank of England and the European Central Bank’s long-term refinancing operations (LTRO), the case for a risk-on trade may be growing.
In the past few years the global economy has been wont to throw out conflicting signals over its state of health. This has understandably fed caution in the behaviour of investors unsure whether positive signals represent early indications of a nascent recovery or another false start.
Yet with central banks maintaining their use of extraordinary monetary policy to avert recession or, worse, a deflationary spiral, the value of a cautious stance may continue to be eroded.
This trend was certainly not apparent through 2011. Over the year, equity markets performed relatively poorly, with the FTSE 100 falling 2.18% and the S&P 500 rising only 1.47% in dollar terms. In contrast, the average fund in the IMA UK Gilt sector returned 16.04%, according to FE Analytics. (AFI continues below)
The three-year picture tells a quite different story. Between March 6, 2009, and March 6 this year, the FTSE Small Cap index has comfortably outperformed the FTSE 100, returning 101.48% to 81.77% respectively. For the FE Adviser Fund Index (AFI) benchmark portfolios the story was similar, with the Aggressive index returning 64.51%, against 42.91% return for the Cautious index.
While most of these gains were achieved between 2009 and 2010, there are indications that the flight to safety that began last year may prove fleeting.
With the yield on 10-year gilts at 2.13% and 10-year US Treasuries at 1.96%, there is a growing debate over how much further these assets can rally. They are already providing negative real returns relative to inflation, with the longer-term debt dynamics in both Britain and America remaining a point of major concern, and many argue that at current valuations the risk is predominantly on the downside.
Ben Willis, the head of research at Whitechurch Securities and an AFI panellist, says: “Compared to our peers we have been slightly more risk on. We weren’t in gilts last year, which hurt us a bit, but we couldn’t see the value in them.”
Charles Bean, the deputy governor of the Bank of England, giving evidence to the Treasury Select Committee last October, said the announcement of a further £75 billion of QE should help support economic growth and push up inflation expectations. “The impact of the earlier purchases on activity was something like 1.5-2% of GDP, and on inflation something like 1.5% peak impact,” he said. “As regards the second phase that we’ve just started, it’s reasonable to think it will have largely equivalent effect.”
The problem with Bean’s analysis is that the economic benefit from the first round of easing came predominantly from the so-called “liquidity premia effect” as the capital injected helped provide an alternative source of financing to otherwise frozen credit markets.
As Fund Strategy revealed last year, the case for the recent rounds of easing appears to rest largely with the portfolio balance effect. This should have quite a different effect to the initial capital injections.
As Bean said in a speech to the London Society of Chartered Accountants in October 2009: “If the asset purchase facility buys gilts from pension funds or asset managers, they will then have to look for another home for their money. As it is not very rewarding just to hold it on deposit, they are likely to look to put their money into other assets, including equities and corporate bonds.”
So there may yet be a significant tailwind to risk assets not despite but, ironically, because of broader macroeconomic weakness. Central banks’ determination in providing support to a fledgling recovery could provide impetus in an otherwise low-return environment.
Willis, however, warns against trying to time markets: “We’ve had a great start to the year but we’re not going to make any knee-jerk reactions from here,” he says. “Though we believe central bank policy will remain supportive, if you try to second guess the political or economic landscape it’s seldom a sensible policy.”
The Bank’s QE programmes and possible further easing from the Federal Reserve might augur well for markets. Faced with a negative real return from “safe havens”, they might prove a gamble investors are willing to take.