Global central banks have undertaken arguably the largest financial experiment in history as a response to the financial crisis.
Traditionally, the role of central banks was to manage inflation by adjusting the overnight rate, the interest rate which large banks use to borrow and lend from one another in the overnight market. However, to lessen the effects of the economic recession, central banks lowered the overnight rate with the goal of influencing the amount of money and credit in the economy. It was hoped that this would then encourage banks to lend, leading to an expansion of economic activity.
With short-term interest rates at zero and no tangible impact on the economy, central banks resorted to unconventional policy measures including quantitative easing and negative interest rates. The unintended consequence of these actions was the reduction in the supply of financial assets, which forced investors into riskier securities such as equities and corporate bonds (see the first chart below).
The debate as to the effectiveness of these policies will be dissected and studied ad nauseam by economists and academics for years to come. However, what can be ascertained at this point, 10 years since the financial crisis, is that the impact on financial asset prices appears to have been more significant than on lending or the real economy i.e. productivity, wages, inflation, etc. This is seen in the chart below.
US equity markets trade at all-time highs and corporate, investment grade and high yield bond valuations are at some of the most expensive levels we have seen since the global financial crisis.
One conclusion we could draw from this is that the divergence between financial assets and economic prices, as a result of this unprecedented monetary policy, has enriched the wealthier households who disproportionally own stocks or other financial products. This is partially responsible for the rise of populism and anti-globalisation sentiment that we have witnessed recently in politics.
Excessive stimulative monetary policy is transitioning towards more fiscal levers, and a modest tapering of central bank balance sheets in the US and Europe appears to be underway. Additionally, inflation across most of the developed markets appears to have troughed, which restricts central banks’ ability, economically and politically, to continue to be accommodative.
Volatility to rise
Although central bank balance sheets and liquidity will remain large by historical standards, it is the decelerating rate of balance sheet expansion that is significant for markets as we believe this could result in heightened capital market volatility.
It is our belief that we have reached an inflection point in liquidity. While central banks have done a great job in suppressing volatility and encouraging investors to extend further out the risk spectrum, our view is this narrative will be challenged as central banks step back from their accommodative monetary policies.
Additionally, political risk, particularly in the developed world, is prevalent and will be another source of increased volatility.
Liquidity and opportunism
As liquidity ebbs, complacency remains high and valuations approach the most expensive levels in a number of years. We believe investors should be cognisant of the level of risk within their fixed income portfolios, as the opportunity cost of not being invested aggressively in a bond portfolio is as low as it has been in a number of years. As such, we believe it is prudent to maintain ample liquidity in portfolios in order to take advantage of market dislocations and invest capital when valuations warrant an allocation.
Flexibility and proper diversification will continue to be critical components of a bond portfolio when navigating through periods of increased volatility. Expect the unexpected, which is after all what drives markets, and position portfolios to be more liquid and opportunistic.