Since the end of the financial crisis the financial market environment has been close to ideal. Moderate economic growth and no inflationary pressure have legitimised the central banks’ reflation policies. This has been good news for almost all asset classes, leading to a “bull market in everything”, as the UK magazine The Economist has aptly put it. The fall in bond yields as a result of central bank asset purchase programmes has enabled bond investors to achieve enormous capital gains.
Phases of above-average capital gains have occurred time and again in the history of the financial markets. What is special about developments in recent years is that both equities and bonds have posted exceptional advances over a protracted period, as the following chart makes clear.
Markets in transition
The past years’ gains have been a boon for investors, but now they are becoming a stumbling block. Climbing asset prices have pushed up valuation ratios in virtually all classes of investment, reducing their further upside potential.
The capital market environment is also changing, spearheaded by the US Fed. Eight interest rate hikes have brought US borrowing costs close to a neutral level. This gradual change of course not only affects the markets in which the central banks have intervened directly. Since the Fed started on the phased downsizing of its balance sheet, we have seen an increase in equity market volatility, albeit from an unusually low level.
Being uninvested is a bad choice
Looming risks often prompt investors to get out of the market entirely. But it is still unclear whether, when and in what form the risks will materialise. Heightened risks and increased volatility do not lead directly to negative returns, especially in a solid environment of robust economic activity and strong earnings growth. Equity valuations are admittedly historically high, but they are not extreme. The same cannot be said with equal conviction of bond yields, but central banks will not quit the field precipitately.
Numerous studies show that in the long term it pays to be invested. Investors receive a return to compensate for the risks they take. Premature exiting from the market can involve substantial opportunity costs in the form of lost returns. Rising optimism in a mature market leads to handsome capital gains, whereas holding cash for a long period results in a creeping erosion of wealth. Inflation (albeit low at present), combined with rock-bottom interest rates in many currencies, eats into the real purchasing power of cash assets.
What should investors do?
We basically advise investors to stay in the market but to carefully examine their portfolios with reference to risks, weightings and individual positions. Strong gains in recent years may have radically altered the portfolio’s structure. Make sure that your portfolio is fit to cope with a more difficult market environment.
Key points to bear in mind include the following:
An excessively one-sided or aggressive positioning should be avoided.
Ensure that your portfolio is sensibly diversified. A concentration of risks in particular sectors, regions, countries, companies or foreign currencies should be avoided.
If you might need to liquidate assets in the future, you should pay attention to the liquidity risk.
Avoid risk assets that generate only a negligible yield.
Bond quality must not be seriously compromised for the sake of a regular income.
Equities of companies with high levels of debt and poor cash flow, especially in cyclical sectors, are particularly vulnerable to correction.
For further recommendations, please refer to our detailed paper on this theme. VP Bank will be pleased to help you identify and calibrate potential risks and to support you in exploiting opportunities in this mature phase of the market cycle. We offer a comprehensive analysis of your securities portfolio in the form of a tailor-made “portfolio check” in which your portfolio’s structure, allocations and individual investments will be rigorously scrutinised. This will involve a systematic quality analysis of your bond and equity positions.