What to do as the liquidity taps close?

The central bank liquidity taps have been open and running full force across asset markets for nearly ten years. However, investors should view the conditions this has provided as more of a mirage than a constant source of liquidity. As the mirage begins to dissipate, we believe investors should focus on bottom-up asset selection, structural diversification based on asset behaviour rather than labels, and a robust approach to monitoring and managing drawdown risk.

As the liquidity mirage evaporates, we believe in focusing on individual asset selection, diversifying portfolios based on asset behaviour, not traditional labels, and taking a sophisticated and energetic approach to managing drawdown risk.

Since the global financial crisis, capital markets have experienced unprecedented injections of liquidity through massive asset-buying programmes implemented by developed market central banks, which 'created' money to make these purchases. This has entailed an unprecedented expansion of central bank balance sheets. The combination of QE and low interest rates has kept yields on short-maturity assets low or negative, despite an apparently strong economic backdrop. This has supported the performance of many asset classes and put many investors on the well-documented 'search for yield'.

Are market participants prepared?

As these programmes begin to unwind and the liquidity taps close, we wonder whether market participants are prepared. We worry that financial markets may be ill-prepared for this enormous change. Investors tend to focus on how a reversal of QE must lead to rising government bond yields (falling prices) as the supply/demand dynamic suddenly reverses. We think a singular focus on this dynamic and its effects on yields and prices is a limited view. It does not take full account of the potential ramifications, including:

  • the attractiveness of cash
  • a fall in the power of diversification
  • a broader withdrawal of liquidity results in volatility.

Cash becomes attractive again

For the first time in nearly a decade, cash rates have begun to look attractive, with 3-month lending rates offering a greater yield than the US equity market. As the Fed runs down the asset side of its balance sheet, the 'reserves' available to the US banking system (which sit on the liability side) will reduce in lock step, draining liquidity from the financial system. It is difficult to know at which point the resulting scarcity of access to money for the banking system might become too much, but if it does, this would put upward pressure on short-term interest rates to increase a willingness to lend. An increase in short-term interest rates marks a relative return of attractiveness for a long-forgotten asset class – cash.

Simple diversification may not be enough

In an environment of rising cash rates, the correlation (a measure of the degree to which the returns on assets appear to move in the same direction) between government bonds and equities increases. Investors who rely on 'naïve' concepts of diversification could then lose money on their equity and bond holdings simultaneously.

Constructing portfolios as liquidity retreats

How should investors prepare for the risk of ongoing liquidity shocks? We believe there are three key levers we can pull, and we have embedded these in the Investec Diversified Income Fund's investment process:

  1. Bottom-up selection of individual assets.

We do not own passive strategies. In contrast to many funds which invest across asset classes we spend most of our time on the selection of individual bonds, equities and currencies based on the attractiveness of their yield, sustainability of income streams and potential for capital appreciation. This results in a more robust set of holdings with differentiated attributes to the broader market. Furthermore, we believe that limiting and indeed scaling back exposure to less-liquid securities, which are vulnerable to elevated volatility (such as high-yield debt or listed 'alternative' assets e.g. reinsurance bonds), is sensible in this environment.

  1. Structural diversification, based on how assets behave, not their labels.

The prospect of bond and equity returns moving in the same direction should trouble many investors who own bonds simply to offset potential losses on equities. We believe that investors should rely not on the label of an asset class, but rather on its behaviour. For this reason, we classify lower-rated corporate debt as representing the same sort of risk as equities. Furthermore, we prefer using strategies, such as options (which are currently cheap due to the absence of market volatility – a key input to their pricing), to provide a reliable offset to equity losses in the event of a market downturn, rather than relying on government bonds.

  1. Robust drawdown management.

We monitor a series of quantitative metrics (such as unusual market behaviour, investor sentiment and momentum), alongside our own qualitative assessment, to decide whether to de-risk the portfolio. We also monitor potential event risks to determine whether specific hedges should be used to reduce the strategy's exposure to an uncertain outcome.

Final thoughts

Central banks are currently the largest participant in the bond markets and they are insensitive to price. Understandably, this creates a vastly different backdrop for global capital markets.

As the liquidity mirage evaporates, we believe in focusing on individual asset selection, diversifying portfolios based on asset behaviour, not traditional labels, and taking a sophisticated and energetic approach to managing drawdown risk.

To read this Viewpoint in full and to find out more about the Investec Diversified Income Fund, please visit www.investecassetmanagement.com/DIF

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Important information

This communication is for institutional investors and financial advisors only. It is not to be distributed to retail customers This communication is provided for general information only. The information may discuss general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. There is no guarantee that views and opinions expressed will be correct. The investment views, analysis and market opinions expressed may not reflect those of Investec as a whole, and different views may be expressed based on different investment objectives. It is not an invitation to make an investment nor does it constitute an offer for sale. The full documentation that should be considered before making an investment, including the Prospectus and Key Investor Information Documents, which set out the fund specific risks, is available from Investec Asset Management. © 2018 Investec Asset Management, which is authorised and regulated by the Financial Conduct Authority, November 2018.