OK, so it's pretty obvious that we're going through uncertain times at the moment. The global economic machine is spluttering, everyone has become an expert in left-wing Greek politics and UK gilt yields have hit rock-bottom.
There are a lot of things wrong in the world at the moment and this is sending ripples throughout financial markets triggering high volatility.
Now, putting on the investment theory cap and a quick look at how the different asset classes rank on the traditional risk/reward chart, it's fair to assume that some asset classes are naturally going to be affected more by market volatility than others.
But these aren't normal times and those assets propping up the foot of the risk/reward chart are not immune to this volatility. Where we are today, in a situation where we could well see the break-up of single monetary union in the shape of the Euro has simply never happened before. This doesn't appear in any text book and quite frankly, all bets are off at the moment.
Take gilts as an example. Historically seen as a 'safe haven' asset to invest in, you'd perhaps think that with the might of the UK economy, this investment wouldn't really be affected by market volatility. Well think again. True, equities are obviously feeling the brunt of the market forces but there are specific events forcing down gilt yields and ramping up volatility specifically in the gilt market.
There are effectively three events driving gilt volatility at the moment so let's take a look at each one:
- The Euro zone crisis – as well as deteriorating global economic data, the uncertainty within Europe has caused 10 year UK gilt yields to fall as low as 1.46% in July 2012 compared to 2.00% at the end of 2011. This in itself shows how 'safe' investors view the UK gilt market and for many investors, this is an attractive proposition in an uncertain world but there's no way that this is sustainable. The problem is that gilts are already discounting a global recession and some chance of a disorderly outcome to the Euro crisis so it's safe to assume that yields will rise over the next 12 months or so.
- Quantitative Easing (QE) –the old "let's print more money to fix the problem" can work but it doesn't half distort the big picture in the process. Since March 2009, there have been three bouts of QE totalling £375bn. The latest round in July saw the Bank of England create new money by snapping up UK gilts. The aim was to lower gilt yields so investors would flock off to riskier assets for something a bit more attractive. The obvious effect of this is that it pumps more cash into the financial system, flooding the economy with liquidity. What has QE done for the gilt market? It's succeeded in pushing yields down but it's effectively rigged the price of gilts and if that's not distortion, I don't know what is!
- Banking liquidity requirements – regulatory muscles have been flexed since the last financial crisis and UK banks have now been imposed with more formal liquidity rules. Institutions are now required to hold larger capital tanks of liquid assets and have been buffing up their tier 1 capital books by purchasing shorter dated gilts. What's the net result of this? A reduction in gilt yields of course!
What does the future hold?
It's clear to see how each of these events is affecting current gilt yields. I think it's also generally accepted that gilts are going to continue to feel the wrath of volatility over the short term given the continued high levels of global supply, sovereign debt fears and general uncertainty over just what is going to happen in the Euro zone and wider global economy.
It's only natural that while yields are low, investors will favour the safe haven appeal of gilts but it shouldn't take much for yields to jump up again and for investors to charge back to equities. Take a break-up of the Euro not happening, and China and USA avoiding another recession and you could be somewhere near that scenario.
As pension investors, it's only right that we keep our long term cap on but what we can't deny is that what we're going through at the moment aren't normal times. I just wonder how many more European political systems we'll all become experts in before the noise dampens and we revert back to the status quo.
Published July 2012
For professional advisers only