IN AN OVERLY COMPLACENT MARKET, STAY INVESTED IN FIXED INCOME
Research Team, 15 September 2017
The headline in major media on 27 June, read "Fed's Yellen expects no new financial crisis in our lifetimes"
Yellen is of course Janet Yellen, the US Federal Reserve Chair, and her comments were largely in the context of the banking system. She does not believe there will be another ﬁnancial crisis for at least as long as she lives, thanks largely to reforms of the banking system since the 2007-09 crash.
“Would I say there will never, ever be another ﬁnancial crisis?” Yellen said at a question-and-answer event in London. “You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be,” she said.
We certainly acknowledge that the banking sector is in a far better position than during the global ﬁnancial crisis (GFC). Banks are well capitalised and subject to signiﬁcantly more onerous regulation, not only in the US but on a global basis, but we think this statement is too optimistic and arguably sends completely the wrong signal.
This message from Ms Yellen does not suggest caution or prudence; instead it could be taken as an invitation to take more risk on the basis that the actions of the Federal Reserve have ’successfully‘ led the US out of the GFC and no similar crisis is foreseeable. One could argue that taking more risk is just what the banking sector did. The day after Ms Yellen’s speech, the Fed announced the top 34 US banks all passed their most recent stress tests, and the immediate reaction of a number of these banks was to request approval to lift their payout ratios. While shareholders will beneﬁt from an increase in distributions, the reduction in capital on banks’ balance sheets arguably puts the banking system in a weaker position.
Stating the obvious, a risk event doesn’t have to originate out of the banks in order to cause a ﬁnancial crisis. Globally, there are many geopolitical risks on the horizon, while asset prices remain elevated. Closer to home, New Zealand’s economic landscape continues to look healthy although we are conscious of record household debt, rising corporate debt and, of course, stretched asset valuations, especially property.
While another crisis over the next few years is not our base case, we do see a high likelihood of a fall in the price of growth assets and we are certainly a lot less conﬁdent that there will be no more crises in Ms Yellen’s lifetime. Peter L. Bernstein, who developed the efficient market hypothesis and is also considered one of the most renowned economic historians and investment managers, gave the following quotes during an interview in 2004 at age 85.
“The riskiest moment is when you’re right. That’s when you’re in the most trouble, because you tend to overstay the good decisions. Once you’ve been right for long enough, you don’t even consider reducing your winning positions. They feel so good, you can’t even face that. As incredible as it sounds, that makes you comfortable with not being diversified. So, in many ways, it’s better not to be so right. That’s what diversification is for. It’s an explicit recognition of ignorance.
There is a tendency for people to expect the status quo either to last indefinitely or to provide advance signals for shifting strategies. The world does not work like that. Surprise and shock are endemic to the system, and people should always arrange their affairs so that they will survive such events. They will end up richer that way than (by) focussing all the time on getting rich.”
We believe these comments provide a succinct and articulate summary of the importance of big picture. Reﬂecting this, our current investment recommendations incorporate an element of caution to protect investment wealth.
Fixed income is an important part of an investment portfolio, adding diversiﬁcation and providing known income streams. Good quality bonds should also reduce volatility, which is important in the event of a correction in equities. These bonds are unlikely to experience the same decline in prices and investors will see the principal repaid within a few years at maturity date.
Please note: This article was first published in the August 2017 edition of News & Views. Craigs Investment Partners clients can view the latest edition of News & Views, which includes the full version of this article, by logging in to Client Portal.