It's all about perception

Increasingly over the last few years, we have been talking to clients about uncertainty in markets, which inevitably leads onto the management of risk. When considering geopolitical risks, traditionally the approach has been that, as it is unpredictable, an event can only be managed after the fact. Even today, after a stream of escalating geopolitical events over the past six months, investor reactions to these events, as well as the increased financial risks, appear very subdued.

Therefore, one of the key overriding features of today’s markets is the possibility of investors being caught off guard. Indeed, we may well be approaching a key moment when investor’s blind faith in authorities to support economies, and bail them out if necessary, comes to an end. At the very least, we should be asking this question and be preparing for this uncertainty.

The entrenched perception amongst investors, supported in the last few years by cheap liquidity through quantitative easing, has arguably dampened the desire for proactive solutions to risks. A part of this may be down to the perception of geopolitical terms; it’s easy to forget that the West has lived in relative stability for the past 25 years since the fall of the Berlin Wall.

In the last few months the following risks, some of which could have been anticipated and some which quite clearly could not, have emerged: the collapse and bailout of the Portuguese bank, Banco Espirito Santo; the temporary suspension of Italy’s third largest bank, Banco Monte dei Paschi di Siena, after it announced toxic loans of over 34% year on year; Argentina’s international bonds default; rising tensions and the subsequent sanctions Russia and the West have imposed on each other; the conflict in Gaza; and the Ebola outbreak in
West Africa.

Despite all of these events, equity investors have retained their seemingly unending sanguine outlook, riding through these uncertainties with hardly a pause for consideration. This equity market ride has no doubt been supported by better-than-expected corporate earnings; indeed, major indices have produced positive total returns in sterling terms against a backdrop of all this significant uncertainty for the majority of 2014 so far.

The story is slightly different when we consider bond investors’ perceptions. On the whole, investors seem to have accepted that record high government debt levels among G10 countries, and the risk that this could dampen growth, is the “new norm”. Similarly, low interest rates held for longer periods of time is the “new default”.

One of the consequences of this perception has been a fall in bond yields, which has meant that investors have been chasing and searching for sources of income outside traditional avenues. This has led to an increase in demand for higher risk, higher yielding assets as investors accept lower quality for the chance of gaining a higher income. A result of going into higher risk assets is often less liquidity in these investments.

One of the higher risk assets that investors have fled to in search of income has been high yield bonds. It may be tentative at the moment, but since July we have seen increasing investor outflows in US-based high yield assets. Relatively full valuations may have caused some of the sell-off, but it may also be due to a change in sentiment with risks such as the Federal Reserve considering exit charges on high yield funds. In terms of the effect on investors, the perception of endless central bank liquidity is unlikely to save the ‘long term’ investor in this environment as the best price and most liquid bonds are sold.

Preparing yourself for these uncertainties, it may require the broader realisation that we no longer operate in truly free markets. Markets today are highly regulated and actively manipulated by both private and public institutions. The current situation in high yield bonds provides a good example of what could unfold. At a time of uncertainty, if valuations and future expectations are reasonable and investor positioning isn’t extreme, the market or investor reaction to an event is likely to be short-lived and less damaging in price terms.

However, if imbalances have built, either via overly optimistic sentiment or stretched valuations, then the outcome is likely to be more long-lasting and damaging for long term investors. Given increased uncertainties and potential liquidity issues in areas investors have fled to in recent years, we may well have to change our blind faith perception of authorities bailing us out and move to a diversified multi-asset approach of tactical portfolio management. Within markets, there will always be a winner and being flexible in our investment outlook will
be key to guiding portfolios through these uncertainties.

Claire Bennison is regional director at Brooks Macdonald in Manchester

She writes a regular in-practice article on asset management for Private Client Adviser