The dangers of investing via the rear view mirror
what feels safe may not be SO...
The radiating reaction and impact of a year marked by Brexit, Trump and other surprises will cause investors to place an even greater importance on investments perceived to offer safety and security (whether they do or not). This behaviour has reached extreme levels, manifesting itself most prominently in sovereign bonds trading at negative interest rates. This means on day one investors are willing to pay more to hold the bond than they will get back in interest and repayment of principal.
Using one of the currently more extreme examples, the purchaser of a Swiss Government 30 year bond at the current market price is locking in a loss of over 55% on their capital if the bond is held to maturity. Granted the Swiss currency is viewed as a safe haven which has great value in times of panic. Many such buyers are forced by regulators to own this assets for reasons outside of this note, and many buyers will not intend to hold the investment for a long period of time.
How unusual is the willingness of the lender to pay the borrower? Very. Negative bond yields are the first of their kind since 3,000 B.C. What a time to be alive!
The following chart shows the trend:
Source: Bank of England, 2015
The accumulation of massive levels of debt has led central banks to the conclusion that loose monetary policy is the only way to ignite growth. This policy has however failed to reignite economic growth. Retail investors that traditionally owned bonds have been driven to progressively increase equity holdings, pushing up prices. Despite this mess, central banks only know how to print more money and will continue unabated. Investors don’t know where to turn - guaranteeing certain losses by buying negative yielding government bonds or equities/property at elevated levels. Investors must take the world as it is and the choices are difficult.
What has worked well in the immediate past - buying low yielding bonds, defensive companies at high valuations or taking an index-tracking approach - is likely to be exactly the wrong approach going forward. Although we have not seen negative rates before we have seen periods of very low rates. What we know from market history is that when the risk-free rate of return approaches zero overall market valuations will compress - meaning an index-tracking approach will not work. Growth will be difficult to come by, meaning that expensive valuations will be awarded to high growth companies. But beware overpaying for such growth. A great company at the wrong price is a bad investment. When central banks are perceived to have exhausted their toolkit to fix the economy, investors will be skittish. Skittish investors tend towards panic. They oversell or over-buy, leading to increased volatility levels (which we have been seeing recently). From fear to fear-of-missing-out. This can lead to opportunities for bargains for calmer heads. Opportunistic stock picking remains important - with price discipline critical.
Rear view mirror investing feels safe and comfortable, yet continuing to do what has worked in the immediate past when circumstances are changing is a dangerous course.