I’m of the opinion that the pandemic hasn’t brought about that many new economic trends. Rather, it’s sped up existing ones.
One of these is the search for safe havens – “safe” assets, typically perceived as some of the lowest risk investments.
Government debt – whether US Treasuries, UK gilts, or whatever else – has traditionally been just that. Low rates had been making government debt look pretty dreary from a returns perspective for a while before the pandemic. But now, with rates even lower, negative yields abound.
Over the past decade, we’ve see the growth of an entirely new sector which aims to protect investors’ money.
Introduced after the financial crisis, absolute return funds aim to achieve positive returns regardless of market conditions. At least on paper, they’re supposed to bear a lower correlation with other assets so that, if the market crashes, they don’t get dragged down with it.
And that’s why AR funds have been under fire recently – a lot of them failed to do what they said on the tin. Despite being designed to provide positive returns – or at least preserve capital – even in the stormiest of markets, one third of them have actually posted a loss, according to the Investment Association’s Targeted Absolute Return sector.
Five funds have seen withdrawals of £6 billion, and 88 out of 119 funds in the Targeted AR sector fell during the first quarter of this year. For a corner of the investment industry that aims to protect clients’ investments, many have done the opposite.
Even if we look beyond the pandemic, over the past decade, AR funds have offered returns of just 3.87% on average.
AR funds that relied on value stocks – essentially “cheap” stocks with strong fundamentals – have also failed to perform this year. In fact, the crash in value stocks has been the sharpest since 1904, according to research from Two Centuries Investments.
What about government bonds?
This leaves many investors in a rut. Where exactly are asset managers going to make money in as safe a way as possible?
US Treasuries have long been the port of call for many investors. But that may be changing too.
A recent report from the Bank of International Settlements (BIS) – essentially the bank for central banks – found that the inverse relationship between stocks and US Treasuries during big stock market sell-offs has become muted over the past couple of years – possibly because, well, who wants to own negative-yielding assets?
Quite a few people, apparently. Central banks all over the world have been about as accommodative as possible in terms of monetary policy – slashing rates to record lows and as a result there’s now $17 trillion of negative-yielding debt sloshing around markets worldwide.
Even China – which is still counted as an emerging market by many investors – recently sold its first negative-yielding sovereign bond to European investors.
Rock-bottom rates have spilled over into the corporate world too. Over $2 trillion of corporate bonds traded in negative territory in recent months.
So this trend has made some of the “safest” debt – government debt – look pretty bland to yield-hungry investors. At the same time, it’s forcing them to pile into riskier assets to make returns.
For many investors, this has made one of the fundamental pillars of portfolio construction look less and less appealing. Some pension funds and risk-averse investors are mandated to hold a certain proportion of government or other investment grade bonds, but those who aren’t may be reluctant to pour money into assets that will sap their returns.
And the prevalence of very cheap money is growing debts to a phenomenal size.
So if AR funds and government debt – supposedly some of the safest ways to grow money – aren’t offering returns, then it leaves the investment industry asking itself some difficult questions.
What can we consider a safe haven nowadays? Does government debt offer “risk-free returns” or “return-free risk”?
That may be why gold has had such a storming year, reaching an all-time high in August. The announcement of a vaccine last month has taken the wind out of its sails a bit, but since the start of the month it’s been making a strong recovery.
And, given that gold remains one of the most enduring safe havens during times of uncertainty, it may have some life in it yet. The end of the pandemic is in sight, but we could be living with the cost of it for a long time.
And that’s why the BIS announced that the market’s current rally may be getting ahead of itself.
The hunt for yield has meant that, even as banks become more cautious about spending, credit spreads have narrowed. Investors, keen to get their hands on assets offering a few percent return from somewhere, have hoovered up corporate bonds.
That’s why corporates in developed economies have been able to issue bonds left right and centre – with most of these boasting the longest maturities too. Corporates bonds with tenors of 30 years (for investment grade debt) and ten years (in the case of high-yield debt) has risen by more than 50%.
That means there’s plenty of investors happy to lend to companies under the assumption that they’ll probably still exist a lot further down the line. But, as the BIS points out, as companies rack up larger debts, so too do they rack up higher debt service burdens – making them more vulnerable to downturns in the future.
In short, that could mean more uncertainty in the future, which is generally good news for the gold price.
So, with this in mind, I’m looking forward to sharing some big news with you this Friday.
Watch this space.
All the best
Nathan Tipping
Research Analyst, Southbank Investment Research
Category: Economics