Yield-hungry investors are being pushed ever-further into risk assets while large parts of the market are also becoming more sensitive to an interest rate shock. Are they prepared for the potential dangers? Emma Cusworth reports.
“There is a currency mismatch in emerging markets, particularly on corporate lending. The question is how much borrowing is in dollars when their income is in local currency? Investors need to consider very carefully where that risk exists as the currency mismatch has often been a big part of emerging market crises in the past.”
Joshua McCallum
Some ironies are truly scary. Despite possessing the knowledge that debt was what drove the world into such desperate waters in 2007, the world is in a more leveraged and more fragile position today as a result of the policies built to protect markets from another crisis of similar scale. Today, markets are walking a tightrope in the blinkered hope it will all turn out ok. After all, the potential shocks out there are all priced in, aren’t they?
As Roger Mattingly, director at Pan Trustees puts it: “We thought debt was bad in 2007 when all hell broke loose, but it is a lot higher now. The numbers are astronomical.”
But it’s not just the debt level that is concerning. Liquidity is massively constrained versus its historic norms at the same time investors are piling into risk assets based on inadequate risk management while currency volatility is putting severe pressure on some emerging markets. Throw political risks into the equation and the pot looks closer to boiling over than simply simmering away in a controlled manner.
And what if that day does come, a shock occurs that wakes people up the extent of risk they are actually exposed to? Can there really be any other outcome than a crisis that could make 2007/8 look like a walk in the park?
UNCHARTED WATERS
True, markets are in uncharted waters. Central banks are “making it up as they go along”, as Paul O’Connor, co-head of multi asset at Henderson Global Investors, puts it and there is no way of knowing how things will turn out in the future, but one read of the International Monetary Fund’s April 2015 Financial Stability Report suggests it is unlikely to be a smooth path to ‘normalisation’.
What we do know about central banks however, is that it is their express intention to destabilise markets.
“The point of super-low interest rates is to be destabilising,” argues Joshua McCallum, head of fixed income economics at UBS Global Asset Management. “From central banks’ point of view, the purpose is to shift the economy out of the path it is on. The whole point is that people aren’t taking enough risk so they cut interest rates to encourage risk-taking. The main channel for quantitative easing (QE) is the portfolio effect – if central banks are buying all the treasuries, everyone else has to buy something else.”
MORE YIELD MEANS MORE RISK
And buying something else is exactly what they are doing. According to analysis into the behaviour of UK insurance companies and pension funds by Vox, the policy portal for the Centre for Economic Policy Research, the ‘portfolio channel’, whereby institutional investors reallocate assets as a key transition mechanism for QE, has seen UK institutions lower their asset allocations to gilts and disproportionately increase their exposure to corporate bonds. Allocations to equities have also fallen while cash has increased marginally.
The thirst for yield is at least partly understandable.
As Mattingly explains: “With yields where they are, pension fund liabilities are incredibly high. This is compounded because of the mismatch in duration for many schemes – as yields fall, they have an exaggerated impact on liabilities.”
To no small degree that feeling of safety is supported by low default rates and an unprecedented almost-guarantee from central banks that interest rates will stay super low for a prolonged period of time.
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