In these extraordinary times for markets it can be difficult for even the savviest of investors to have confidence in their investment decisions. Central banks interventions have helped drive markets onwards, but are the effects of unorthodox policy building up problems for the future?
Across much of the developed world central banks are undertaking large-scale asset purchase schemes in attempts to stabilise, and in some cases to boost, crisis hit economies. While fears that these measures would lead to Weimar-style hyperinflation have proven wide of the mark a combination of central bank purchases and the demand for safe assets due to increased uncertainty is putting significant stress on bond markets.
You do not have to look far to see this in action. At the time of writing the yield on the benchmark 10-year US Treasuries is 2.17 per cent with inflation running at 1.1 per cent. In the UK the situation is even worse for investors looking for income with 10-year Gilts yielding 2.07 per cent but CPI inflation at 2.4 per cent – that is, a negative real yield.
Even in the troubled eurozone spreads are falling with France’s 10-year yield falling to 1.7 per cent on April 23, its lowest level point since 1990, although they have since crept back up.
So far the high price for safety has not dissuaded people from continuing to mop up these assets as soon as they hit the market. What this means, however, is that those hunting for income above inflation are being pushed further and further up the risk spectrum.
Patrick Armstrong, chief investment officer at Armstrong Investment Managers, says: “Yield is definitely driving investment at the moment, even junk bonds and emerging markets have seen spreads contract sharply. If you get an unexpected jump in interest rates it could have big repercussions with projects that assumed current funding costs would last failing.”
As Armstrong alludes to this “reach for yield” also poses systemic risks owing to misallocation of investors’ capital. Ploughing money indiscriminately into high-yielding fixed income instruments could mean that the economic consequences in the event of a rate rise will be all the more severe.
A recent paper from the Harvard Business School entitled “Reaching for Yield in the Bond Market” looked into this phenomenon in some depth. The authors state:“A key principle of finance is that in equilibrium there is a positive relation between the risk of an asset and its expected return. Comparisons of returns, therefore, are only meaningful on a risk-adjusted basis. But risk cannot be measured perfectly. This creates an important limitation in the delegation of investment decisions.
“Financial intermediaries and investment managers that are evaluated based on imperfect risk metrics face an incentive to buy assets that comply with a set benchmark but are risky on other dimensions; in other words, they have an incentive to ‘reach for yield’. This could lead to excess risk taking in financial institutions, a persistent distortion of investments and, potentially, amplification of the overall risk in the economy. Indeed, reaching-for-yield is believed to be one of the core factors contributing to the buildup of credit that preceded the recent financial crisis.”
This squeeze on yields has led to a number of commentators warning of a bond bubble. This is understandable as the performance of almost all bond classes since the onset of the Great Recession has been impressive and has now weighted risks towards the downside. Nevertheless, there as yet there have been few signs of a sudden implosion in bond capital values.
One of the main problems, as the authors of the Harvard report suggest, is that in the meantime the misallocation of capital towards companies with precarious finances could increase the vulnerability of economies to sudden shocks once interest rates begin to rise. If so, this suggests that the regulators should be paying close attention to developments within bond markets.
A shift in focus – but not (yet) a Great Rotation
Of course, the hunt for yield in an ultra low interest rate environment was always going to have some distortionary consequences. The impressive rally of fixed income assets across the risk spectrum over the past five years indicates one of the ways that this has been manifested.
Yet while fixed income spreads have been squeezed investors competing for a diminishing supply of inflation-beating income streams are being pushed to take on ever more risk. This has meant that dividend paying stocks, particularly blue chip companies, are now vying ever more strongly with bonds for investors’ attention.
This strategy could be all the more interesting if rumours of a shift in central bank asset purchases are accurate.
For those familiar with the Bank of England’s description of quantitative easing it should come as little surprise that stocks would be one of the beneficiaries of current central bank policy. One of the central transmission mechanisms of QE is the so-called ‘portfolio balance effect’ where investors are forced out of ‘safe haven’ assets into higher risk investments.
What is perhaps surprising, however, is that despite the recent rally on some metrics equities not only look cheap relative to other asset classes, they look exceptionally cheap. A recent paper written by Fernando Duarte and Carlo Rosa of the Federal Reserve Bank of New York suggests that “most [central bank] models predict that we will enjoy historically high excess returns for the S&P 500 for the next five years”.
This, the authors posit, is down to the fact that the equity risk premium – or the expected rate of return minus the risk free rate – is at its highest point since the start of the data.
Furthermore Bloomberg reports that in a survey of 60 central bankers this month by Central Banking Publications and Royal Bank of Scotland, 23 per cent of respondents indicated that they own shares or plan to buy them. Already the Bank of Japan, the Bank of Israel, the Czech National Bank and the Swiss National Bank have all moved to increase their equity holdings.
If this trend continues it could have very interesting implications. Bond purchases, by their nature, have a fixed capital upside limiting the return that investors could get by riding on the coat tails of central banks. These constraints, however, do not apply to equity prices.
These drivers might help to explain the net retail inflows into equity funds eclipsing those into bond funds over the past two quarters. Over the fourth quarter of 2012 and the first quarter of 2013 net inflows into equities were £2.12bn and £1.74bn respectively according to the IMA, compared with an inflow of £432m and a net outflow of £164m to bond funds.
Yet before suggesting that Mrs Miggins plough all of her metaphorical life savings into equities one might ask how it is possible for these markets to seem so promising while economic growth in the developed world is still far short of what could be considered a recovery trajectory?
And as the Bard would say – Aye, there’s the rub. A high equity risk premium reflects both the assumption that the rate of return from the asset class will be largely in line with its long-term average and the fact that ultra low interest rates have pushed the risk-free rate down to historically low levels.
In these exceptional times it can quickly become unclear what constitutes euphoria and what is a reflection of structural shifts in portfolio managers’ risk tolerance. As Toby Nangle, head of multi-asset at Threadneedle Investments, says:
“By bidding yields on government bonds down to current levels, monetary policymakers have largely extinguished government bonds as an effective portfolio hedge. Investors can now decide to either increase their risk appetite on a structural basis and hold more risky assets (that is to say assets that are positively correlated with equities), or increase their cash positions and hold less equity than they would otherwise do to retain the same level of portfolio risk.”
Unfortunately this clash between Econ 101 and Portfolio Management 101, or so Nangle dubs it, makes an analysis of the current situation immensely complicated. There is no doubt that overall equity markets appear to be less stretched than investment grade and high-quality government debt markets but as valuations creep up so alarm bells should start ringing.
Moreover, there are key questions to answer about responsible portfolio management in an environment of above-target inflation and near zero returns on cash. The cost of staying on the sidelines, even if markets do look expensive, may impose significant pressure on managers to act against their better instinct.
Market dysfunction or risk management?
Some see current bond prices as a clear sign of a bubble, demonstrating that investors are chasing after past returns. However, it is not as clear-cut a case as many imagine.
Nangle suggests portfolio managers are being forced to make a decision between holding cash and increasing portfolio volatility. For some, in particular pension fund managers, the latter is simply unacceptable – they have liabilities that must be met – so in the interim even assets with a negative real yield are preferable to structurally increasing portfolio risk.
This in itself offers an explanation for why we have yet to see a rotation out of fixed income. What may be underpinning its resilience is cash on the sidelines that is ready to snap up assets as soon as yields begin to creep upwards.
Keith Wade, chief economist and strategist at Schroders, explains:“A lot of the liabilities that pension funds have are maturing and they have a very clear need for funding over the next 20 years or so. From their perspective they are looking for assets with an inflation-linked yield that can provide a stable cashflow. Unfortunately these assets are really quite expensive at the moment. ”
Small prices falls therefore become a buying opportunity for income-starved pension funds. This keeps the yield from moving too far outside its current range – although we have seen the first major tick up in global government debt yields on the back of strong US growth figures that raised the spectre of a slight pullback by the Federal Reserve.
The dynamics of the market, however, still puts a lot of pressure on central banks to maintain the status quo, which could pose a challenge when central banks decide it is time to taper their programmes.
“We have moved very light in government debt over recent years and into credit, equities and real estate as we are being forced to by central banks,” says Andrew Milligan, head of global strategy at Standard Life Investments. “The clear danger is that by manipulating interest rates this much, credit markets are getting false signals. As such the withdrawal of the programme is very unlikely to be easy.”
Indeed the market reaction to even small signs of a pull-back by the Federal Reserve demonstrate the stakes in this game. Ben Bernanke’s hint in testimony to Congress that if stronger-than-expected economic data came through it might mean that “[the Fed] could take a step down in the next few meetings” caused huge ripples through global markets.
In the week ending 5 June worldwide bond funds saw collective outflows of $12.53bn (£8bn), according to EPFR Global. Much of this was seen as an overreaction to Bernanke’s speech, in which he also noted that “premature tightening [would] carry a substantial risk of slowing or ending the economic recovery”. Yet it is strong evidence that the current rally across asset classes is being maintained on the assumption of continued central bank support.
The challenge for policymakers now is knowing what to do in an environment where further QE purchases of government debt is unlikely to do much to stimulate the real economy – in fact it is increasingly seen as counterproductive (at least in the UK).
“Government bonds in most markets have played out pretty much as far as they can and it is not completely clear what the next asset targeted by central banks will be,” says Nangle. “I personally think that QE tends to look counterproductive for the UK.”
His caution is based on the term structure of UK private sector balance sheets. Unlike in the US, where 30-year fixed-rate mortgages are not uncommon, UK household borrowing is overwhelmingly weighted towards floating rate or 0-10 year fixed-rate mortgages. As such targeting a reduction in long-term bond yields is consistent with looser monetary conditions in the US, but may perversely be causing tighter monetary conditions in the UK.
This implies that the available stock of assets that the Bank of England can target is much more limited than its US counterpart. Moreover it might also explain why pension fund liabilities have increased at a faster rate than the degree to which asset values have increased.
As Nangle wrote in an investment note last December this occurred primarily because “long-dated bond yields are used to discount the present value of those pension liabilities, and these yields have been driven lower by QE”.
So pension funds have been forced to hoover up income where they can find it, exacerbating the shortage of ‘safe assets’ for the rest of the market. This in itself constrains lending in the shadow banking industry, which relies on these assets as collateral.
So what can be done?
The reaction of bond markets to even the suggestion of tapering monetary policy measures should be an indication of just how vulnerable current momentum is in markets. This is despite apparent improvements in the US economy.
Is it that monetary policy alone cannot ensure a self-sustaining recovery? As The Economist’s Matthew Klein wrote on Twitter: “Why would Fed policymakers be happy with inflation and job growth both so far below target?”
There is no doubt that the performance of the US has been significantly better than the UK, but it is notable that the divergence in economic trajectories occurred after 2010. This, coincidentally, also marked the beginning of fiscal consolidation efforts by the Coalition government.
Despite protestations from market monetarists, who believe that fiscal policy can be offset by central banks, the UK has effectively seen its economy stagnate for the past three years. Indeed policymakers in Britain would be wise to listen to Bernanke’s warning over the US’ sequester:
“The expiration of the payroll tax cut, the enactment of tax increases, the effects of the budget caps on discretionary spending, the onset of sequestration, and the declines in defence spending for overseas military operations are expected, collectively, to exert a substantial drag on the economy this year…Monetary policy does not have the capacity to fully offset an economic headwind of this magnitude.”
Accommodative monetary policy can and has been successful in providing breathing room for fiscal policymakers to address structural weaknesses in the economy. Yet if the result of “offsetting” fiscal consolidation is medium term stagnation, or worse, then it can hardly be called an optimal policy mix. That is the clear message that Bernanke gave Congress and it is one that should carry over the Atlantic.
It is a matter of some urgency. The window that central bankers have bought governments will eventually close as the untoward effects of ultra low interest rates and asset purchases begin to exact a heavy toll and increase “the overall risk in the economy”.
“The Fed has taken a calculated risk that the pace of fiscal consolidation is manageable but there is a lot of frustration from central bankers about politicians squandering the time they have given them,” says Milligan.
“Could it become a drag in future? If we get two to three more years of political gridlock bond markets may get worried. Over time the supply/demand dynamic for government debt will normalise and government credibility will then be called into question.”
At least, though, the US economy has some momentum. If America is yet to reach escape velocity, the UK by contrast remains stalled on the launch pad. So while pointing the finger at government cuts may be an easy answer, offering a solution to the current malaise is more difficult.
One of the reasons for our present stagnation is that the financial crisis has fundamentally impaired a key cog in the transmission of asset wealth into the real economy – the banking system. While it continues to deleverage and plug balance sheet holes we are unlikely to see a pick-up in lending, irrespective of how much incentive we throw at them through Funding for Lending, Project Merlin and other schemes.
“We have had a big shock to the system and people really are notin the right places to facilitate the flow of capital from investors to borrowers,” Wade says. “I think that dislocation occurred because of the banking crisis as the intermediary function that the system played has been impaired. So it requires new channels to be created to get money to work in the real economy.”
Those channels could be direct government investment, the issuance of inflation-linked infrastructure bonds to soak up pension fund demand or the creation on new financial institutions that can link cash-heavy investors with promising projects. I suspect any answer that seeks at address the private sector investment strike and long-term financial sector reform will have to involve all of the above.