BlackRock's Charles Prideaux explores what might happen if governments begin to abandon their quantitative easing policies.
Last year will be remembered as an eventful but ultimately positive year for investors. In dollar terms, the MSCI Investable Market index gained a highly respectable 13.45%, while the Barclays Global Aggregate Bond index delivered a total return of 4.32%.
As we move into 2013, stabilising global economic growth continues to support a more optimistic view on the prospects for risk assets and the world economy. However, the path to full recovery remains highly uncertain, with policy continuing to be a prime determinant of investor returns. The big question for the year ahead is whether the wave of ultra-loose monetary policies and quantitative easing has crested. Trillions of pounds in monetary stimulus and record-low interest rates have failed to spur much credit growth and economic activity so far, but could this change?
The most likely candidate to reduce monetary stimulus is the US Federal Reserve. The US economy is growing and looks to gain momentum if – and it remains at this stage a big if – Washington can find a credible cross-party solution to address the deficit. US banks are in reasonable shape, manufacturing is rising and the housing market has turned, boosting consumer confidence and spending. We do not expect the Federal Reserve to raise rates soon but there is a possibility it could take the foot off the gas pedal on signs of quickening job growth in the second half of 2013. This may seem unlikely today, but institutional investors positioned to find yield in a low-yielding world need to be ready.
Even a slight change of tack by policymakers would have a material effect on markets. Vast stores of investor assets are held in cash and low-yielding fixed income assets. Rate rises would prompt many investors to seek higher returns in riskier assets in the belief that policy had resulted in an improved growth outlook. Once markets get a whiff of a change of sentiment among policymakers, the movement out of some fixed income assets could be profound.
In this environment, supposedly 'safe', low-duration fixed income assets might not be so safe. Casualties would be assets such as government bonds of the US, UK, Germany and other core euro-zone countries, whose prices would fall as yields started to rise. Given how low yields have fallen, it now takes just a small rise in yield to trigger sizeable bond price losses.
In addition, quality businesses and dividend stocks would likely underperform leveraged companies, as the influx could result in a temporary dash for riskier assets. There is a danger in safety because most investors are positioned for rates to be low for long. Granted, a limited supply of bonds could mitigate the effects of pro-risk migration, but it still represents a meaningful risk. Conversely, for investors with liabilities who are looking to extend their liability hedge, any reversal potentially offers opportunities. However, these can only be seized if investors pro-actively prepare by putting in place a robust monitoring mechanism and implementation process.
On the return side, institutional investors with funding challenges must continue to position themselves to seek yield in this low-yield environment – but they must also be vigilant in the event that monetary policy changes direction. To prepare, institutional investors need to identify areas of value in their portfolios – and pockets of overvaluation or risk. This is because, in a very low-yield environment, the widespread hunt for yield has narrowed valuations between top quality and lower-quality assets. Some investors are sacrificing safety and liquidity to gain incremental amounts of yield.
This narrowing spread between quality and less desirable assets is playing out in every corner of the yield-seeking world. Investors are climbing up the risk ladder, as evidenced by increasing interest in emerging market debt, and while we are strong believers in the merits of an appropriate EM debt allocation, it points to the need for a more robust investment framework to identify and manage attendant risks effectively.
Mandates, accounting rules and regulatory changes limit the choices available to institutional investors and arguably focus them on short-term results. There are signs of rethinking this – already we see many investors looking to adapt their portfolio guidelines – but material changes will not occur overnight. Given this, the case for a multi-asset, multi-geography approach to yield investing becomes stronger. If some assets are going to increase in value significantly with others suffering commensurate losses, a balanced and flexible approach across a wide range of strategies, including less traditional segments, may be the best route to take.
Charles Prideaux is head of institutional business for the EMEA region at BlackRock