Reach for Yield & Black Swans: A context for recent volatility
QuayStreet Asset Management, 13 March 2020
As the advent of coronavirus and an oil price shock set the tone for a turbulent 2020 in markets, it is timely to reflect back on where we are in the investment cycle and how we got here. Whilst much of this won’t be news to many investors, it is intended to provide a piece of background context for understanding current volatility.
Reach for Yield
For much of the developed world, the 2010s in markets was a decade characterised by accommodative monetary policy: easing of interest rates, central bank asset purchases to inject liquidity, and a none-too-subtle bias towards appeasing markets. Whilst this has underpinned a period of relatively low volatility (in contrast to the GFC), it has also had some less favourable consequences.
Notwithstanding the distortions in markets and a resurgence of financial engineering, a key impact on individual investors has been the effect of highly accommodative policy on distributions, seen not only in depressed interest rates on bank deposits, but also in contracting yields on investments such as shares and property. These have largely been a function of the prices for these assets rising much faster than the income streams attached to them.
For investors relying on regular income streams such as interest and dividends, this has put many between a rock and a hard place: either accept lower income on investments, or move into riskier assets seeking to maintain a given percentage rate of passive income.
Making matters more difficult was firstly the fact that this ‘reach for yield’ was occurring throughout the developed world, and secondly that the competition for assets created by more new money flowing into markets invariably led to prices rising across the board. Locally, this phenomenon has been quite visible in equities, and to a lesser extent in bonds and property.
The experience of capital gains resulting from the rising tide has helped to create a feedback loop of reinforcing behaviour, stoking additional demand for risk assets and pushing prices up further.
In a normal business cycle, the signal of overheating asset prices is usually cause for governments and central banks to tighten policy around access to credit and interest rates. However, during this cycle, the bias of global central banks has been to let things ‘run hot’ in an effort to generate inflation and promote full employment. Directly, the tailwinds of cheap money and additional liquidity have provided support to risk assets. Indirectly, the bias has also promoted an expectation that further accommodative policy would backstop any significant fall in asset prices.
This has been illustrated by US equity markets through much of 2018 and 2019, whereby a combination of policy and signalling in response to market apprehension led to an environment in which markets seemed impervious to bad news. In the same way that conditioning can create a learned response in man’s best friend, markets became conditioned to behave as though the emergence of volatility would be quelled by policy intervention.
For most of the past decade, this broad thematic has held sway, which helped drive an increasing disconnect between earnings and valuations in many segments of the market. One way of visualising this trend is the expansion of P/E multiples.
Taking the New Zealand market as an example, at the end of January 2010, an investor buying the NZX 50 index was paying about $16 per dollar of expected earnings. Fast forward a decade to January 2020, the ‘price’ for a dollar of expected earnings had increased to $27, an increase of around 70%.
All else being equal, the higher the level of valuation, the further the fall back down to earth when a negative shock hits the market. This effect tends to be exacerbated when there is significant uncertainty surrounding the shock, and especially when its impact is difficult to quantify. Importantly, an environment of high valuations doesn’t mean there are no opportunities to invest, although what it does mean is that investment selection and awareness of risk become more important. In other words, when there is less margin for safety, it usually pays to exercise more caution.
With this background as a frame of reference, it becomes less challenging to interpret current turbulence in markets, whose precipitating causes have been the coronavirus, and more recently, a large oil price shock brought about by discord between oil producing countries.
Both of these causes fit the definition of a ‘Black Swan’, which describes an unexpected event, with potentially major consequences, and that is difficult if not impossible to predict with any certainty. The simile was popularised in the eponymous book by Nassim Nicholas Taleb on probability theory.
Because Black Swan events tend to be historical outliers without precedent in living experience, there is seldom a practiced response to them. Not being equipped for the event, the reaction most often defaults to panic or paralysis. The former is what we have been seeing with regard to recent volatility in markets.
For several weeks around Chinese New Year, as the coronavirus was beginning to spread from China’s Hubei province, media airplay grew, but the issue did not translate into alarm outside of China. Until late February, markets were on the side of being unconcerned, on the premise that the virus would be as a relatively localised outbreak with impacts likely to be short lived. Carried by this narrative, most major markets outside of China largely took ongoing news flow in their stride, focussing greater attention upon the forthcoming US election and the Federal Reserve’s liquidity operations.
Then quite abruptly, markets began to worry. Monday February 24th marked a turning point in sentiment as participants began to price in the impact of second order effects, such as disruption to global supply chains and curtailment of travel. By the end of the week, the Dow Jones index in the US had fallen by over 12%, and New Zealand’s NZX50 almost 7% from where they closed the previous Friday. In a short space of time, the narrative morphed: it now presumed spillover impacts into many parts of the real economy, with the global aviation and tourism sectors most visibly at risk.
So, other than the simple justification that markets suddenly ‘woke up’ and began to earnestly price in risk, how else can we understand this volatility? One useful way of looking at it is through the lens of markets growing too accustomed to benign volatility. If markets get used to a period where reactions to news are muted, then gradually, they become more susceptible to having a violent reaction when a significant enough piece of news comes along.
With the twin catalysts of coronavirus and an oil price shock, this ushering in of a chapter of high volatility has now eventuated, and it remains to be seen whether it will be a passing phase or a more enduring feature of markets in months to come.
Considering the unknown final effects of the coronavirus and the added uncertainty around the oil price, we are now in a period where we expect large moves in markets to be a much more common occurrence. Whilst we anticipate this type of whipsawing environment will likely throw up opportunities, our outlook remains cautious.
Our current prognosis is that disruption and impacts of coronavirus will likely be more than a quarterly blip, and that markets will react to news of any prospective vaccine early. Given vaccine development cycles, we think a twelve month timeframe would be a best case scenario. In terms of oil, the silver lining is the easing of cost pressures for consumers and businesses. Though the discord between oil producers could turn on a dime, in the interim, lower fuel prices will be a small but welcome consolation for many industries. We also remain cognisant of cascading effects, particularly in credit and funding markets, where adverse developments could be more consequential for the real economy.
In a complex and developing situation where there is a very wide cone of uncertainty around what may or may not eventuate, QuayStreet’s diversified funds are currently tilted defensively, and are carrying higher levels of cash to insulate against downside risk. As events unfold and more information becomes available, we continue to actively assess valuations and manage risk exposure, with a view to deploying cash where we see favourable opportunities.
As investors, we acknowledge that periods of high volatility are uncomfortable, and manage each of our funds with the objective of generating appropriate returns without taking undue or excessive risk. In an environment of heightened uncertainty, a weighing up of expected returns against risks takes on even greater importance. We encourage investors to take stock of their position and make this same assessment.
Ensuring your investments are suitably aligned with your appetite for risk and time horizon is an essential step in setting up to achieve your financial objectives. This is especially relevant for investors who are likely to draw-down on their investments in the near-term, for example to buy a first home or pending retirement.
QuayStreet offer a broad range of funds to cater for different investment objectives and risk profiles. For more information on our funds and how they could suit your investment needs, contact the QuayStreet Service Team on 0800 782 900 or [email protected]