Markets have been so distorted by central banks printing money that the old rules no longer apply. The deflation of this bubble will be a problem for all asset classes. Historically, diversification has been a sensible way of lowering risk in a portfolio. Unfortunately, this no longer works. When investors diversify their portfolios, they are, often without knowing it, simply choosing different levels of volatility. Sadly, it has become the case that most asset classes now move together, and this even applies to bonds.
In the first quarter of 2022 equities have had a bumpy ride. The war in the Ukraine has been an important factor but there is also profound underlying change in the inflationary background. Central bank behaviour has changed. While central banks initially moved slowly, they are now finally acting to raise interest rates and stop quantitative easing: there is even the real prospect of quantitative tightening. The move to quantitative tightening – central banks selling bonds that they had previously bought back – should be especially concerning for investors, as it sucks liquidity out of the system meaning investors literally have less money to play with. Central banks are no longer the market’s friend.
A traditional diversification strategy would be to add fixed income to what would otherwise be an equity portfolio. So far this year this strategy has proved to be a poor one. In the first quarter of this year, as it became clear that central banks were changing direction, government bonds saw their worst performance for decades (Western sovereign bonds on average lost around 10%). The previous era of quantitative easing led to a flood of liquidity that lifted all the boats. As the tide goes out all the boats will fall, some more than others. In a liquidity driven bull market, it is often the most speculative assets that do best. Few investors are interested in traditional, fundamentally driven investments such as utilities or mining companies. These seem dull by comparison. As liquidity declines, we suspect this trend will move into reverse.
If the liquidity boom is now deflating what can investors do?
For many similar periods in the past cash and patience would have been a simple and effective strategy, but with inflation approaching 10% in much of the world, this seems like a losing approach. Short term bonds are little better. Long term bonds have the potential to do even worse. Despite the poor performance from fixed income, it is remarkable that UK 30-year government bonds still only yield 1.9%. Over the last forty years the average yield on the UK 30-year has been around 6%. Just as an illustration, if the UK 30-year government bond yielded 6% tomorrow, investors would lose about one-half their money.
Many investors will consequently prefer equities to fixed income. There is some logic to this as some companies can increase their prices in response to higher input inflation. However, as the liquidity boom grew some equities became expensive. Using cyclically adjusted price to earnings ratio as a measure, US equities are now more expensive than they have ever been outside the dot com bubble. Equities are also facing rising interest rates, falling liquidity, a potentially slowing economy and stagnating earnings.
Source: Shiller PE ratio http://www.econ.yale.edu/~shiller/data.htm
So, if bonds are dangerous, if equities are worrisome, and if cash is a guaranteed loss of real value, what can an investor do? This is where we believe that, rather than focusing on asset classes, we need to move to a more nuanced strategy of assessing individual investment opportunities across classes.
At Woodhill we built our investment approach for exactly this type of environment. Through a variety of economic, sentimental and valuation measures we attempt to navigate investors through what could well be difficult times ahead. We assess risk and reward and only put investors funds at risk when we believe the ratio of risk to reward is favourable.
The liquidity bubble is almost certainly over, and all the rules have changed.
Author: Paul Wood CIO of WoodHill Asset Management.