Risk and Portfolio Construction: All change
The big challenge in setting investment strategy today is that markets continue to be under the thrall of ultra-easy money and collapsed interest rates, much as they have been for the past seven years. Just about everything in the central bank armoury is in use – zero interest rates, forward guidance and unprecedented direct intervention to hold the entire yield curve below market clearing levels.
This has made interest rate movements highly unpredictable. Bond yields came off their lows last year on views that rising rates were approaching, only for the US Federal Reserve to promptly row these expectations back. The scaling back of bond purchases this year reflects limits on the growth in the US central bank’s balance sheet becoming intolerable, but it is being balanced by stronger forward guidance. The bottom line is that the market’s call that short-term rates will be moving higher in the first half of next year could easily be wrong.
Let us be clear. We are not saying that the market is wrong, but rather that there is a clear risk that the view is wrong. Ordinarily, given the economic growth, inflation and decreasing unemployment rates being seen in the US, we would expect interest rates already to be rather higher. The fact that they are not gives an indication of how much guesswork is involved in timing interest rate moves. It is all very hazardous.
And here’s the problem. Rolling down the yield curve – rolling from a lower priced, longer duration bond to a higher priced, lower duration bond – has been lucrative. The markets have regularly overestimated how quickly the Fed will move. Should we not bet on more of the same? And in a broader investment context, if policy rates will only begin rising in three years’ time and not next year, should we carry on backing yesterday’s market winners rather than changing strategy?
This broader investment context is all about central bank policies pushing investors into reaching for yield. This has embraced a wide range of risky assets – from high yield bonds to mortgage backed securities, real estate to farmland, from equities with an income to equities with only the promise of one. More to the point, it has delivered for bonds as well as high-risk growth assets. The normal assumption that what is good for equities is bad for bonds only held for 2013. Look further back and you will see that both stocks and bonds have delivered. The Barclays aggregate index is up over 50% in the last five years and equities have delivered a multiple of these returns.
This raises two key questions for investment strategists. First, how quickly should investors expect to see yields rise, and second, will we see a reverse in current market behaviour with bonds and risky assets both underperforming?
We see risks tilted towards a faster rise in yields than the market expects. This is not because central banks will move earlier, but because what is priced into the market for future short-term rates are too low. The UK Gilt market is currently saying that the bank rate could be at or even below 3% as late as 2019. Unless you assume persistent economic weakness and very low inflation, this makes little sense.
If market rate expectations adjust upwards as we expect, bonds will return even less than current low yields suggest. Also, the yield curve will flatten, led by shorter durations, which will make curve roll-down strategies less lucrative. In our view, we need to stay worried about duration risk and not be seduced by higher yield at distant parts of the Gilt or corporate bond curve. Additionally, risk parity strategies may also have a little less going for them given their typically higher allocation to bonds.
We do, however, see the risks to our interest rate view as two-sided, even if they tilt towards higher rather than lower yields than those currently priced into curves. Central banks may continue suppressing interest rates for longer. This has particular relevance to LDI. Normally, a view like ours would suggest under-hedging. Precisely because the risks are not tilted just in favour of higher yields, and because it is important not to let tactics take over strategy (liability hedging is all about that), our preference is to be nearer to full hedging of interest rate-linked liabilities.
The question over broader investment strategy we asked earlier is even more difficult. We do see an elevated risk of bonds, equities and other risky assets doing badly together. We have already had a taste of this through summer 2013 and unfortunately the risks of this scenario have increased with valuation levels in equities and credit looking fuller. Credit markets have, in particular, been a victim of their own success and look increasingly crowded. Here, relative value can now be almost the only focus – picking out segments less exposed to interest rate risk and less vulnerable to a reversal of credit risk premia.
The extreme case is that a wide risk-asset market meltdown could come if interest rate expectations adjust quickly upwards at any time. However, our working assumption is for something milder. As yields rise, we see choppier public market conditions with lower returns and higher volatility. This makes it an excellent time to be seeking out other sources of return less correlated to equities and credit. Investment approaches embracing less market directionality (certain hedge fund strategies) or non-public market investments (private debt, infrastructure, commercial property and some less exposed private equity segments) would fit the bill.
In other words, while we do want to re-orient portfolios away from the winners from ultra-low interest rates, timings this right is not easy. The low interest rate environment has made fools of many and kept markets abnormal for years, and we cannot be certain that it is all about to change quickly. We need to feel our way as we change direction, but when all is said and done, we do believe that it is time to prepare for something different.
Tapan Datta is head of global asset allocation at Aon Hewitt