19 January 2018, 17:25 GMT
Negative interest rates forcing more risk-taking
In Europe, this demand for yield is very pronounced. The culprit is the negative interest rate. The European Central Bank’s monetary policy objective is to maintain price stability. In the ECB’s eyes, it’s the setting of a suitable interest rate that’s important. Whether or not that suitable rate happens to be negative is largely irrelevant. But negativity is relevant to investors. They commonly desire that at least their capital is returned.
When the interest rate is at its normal level, an investment in that risk free asset guarantees capital plus interest will be returned. As more investment risk is taken, the probability of making a loss rises, negligibly at first, but reaching about 10% for a bond portfolio. The probability of loss doesn’t rise indefinitely because additional risk is accompanied by additional expected return. Instead the probability eventually settles at a level of around 30%-40% of loss, once equity-like risk is taken. Therefore, a suitable portfolio would be one of maximum expected return given the investor’s stated probability of loss. That stated probability represents the investor’s aversion to risk.
However, when interest rates are negative, a bank deposit is guaranteed to lose capital. In this perverse environment, investment risk is needed to reduce the probability of loss. European bonds have roughly a 50% chance of loss. It is only asset classes such as investment grade and high yield corporate bonds, equities, and alternatives where the investor has better than 50% chance of returning capital. In a world of negative interest rates, the desire for preserving capital is a measure of risk tolerance, not risk aversion. I showed this concept graphically to a European investor last week with the chart below.
To preserve capital a European investor must take risk, and they are doing so to a significant degree.
Potential triggers for a market downturn
Of course it’s easy to be risk tolerant when all markets have performed so well. That could easily change if markets turn down. Excess risk taking usually leads to a panic - the longer the risk taking continues, the bigger the correction could be. But none of the few wobbles we’ve seen in equity markets over the last few years have caused investors to run. Instead, dips have been perceived as buying opportunities.
What could change this, and hence cause a market downturn? I see two triggers:
- Interest rates rise, returning us to a normal environment
- An exogenous shock hits the market (for example a political event) and investors become uncomfortably aware of the inflated levels of risk they are taking.
The ECB remains incredibly conservative (wrongly so, in my opinion, as it’s fuelling the behaviour described above). The recently released minutes of the ECB’s December meeting hint at an end date to asset purchases being announced. But that’s still tapering QE - let alone a rate rise. And in response to these hawkish minutes, the Euro appreciated aggressively, alarming several ECB members. It remains to be seen what the ECB will say at their meeting next week, but I suspect this all implies Euro interest rates will probably remain negative for all of 2018.
I therefore find it hard to see a switching of the investor behaviour to risk aversion, and hence expect the demand for yield to rage on.
Need for vigilance
By definition we won’t foresee an exogenous shock, but high-frequency price action after such an event will tell us a lot about investors’ tolerance for a downturn. If such an event occurs, but the price dip is shallow and short-lived, it will indicate another risk-on year ahead.
Seldom has a need for vigilance by an asset allocator been this high. My attention is therefore on:
- The behaviour of the European Central Bank,
- Developments of inflation, and
- The technicals of the equity market.
For now those warning lights are green, but change could come very fast. I’m risk-on, but favour taking duration in the US rather than Europe where a repricing of a lagging central bank feels materially more likely.
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