Need for Yield – By Daniel Gauci

Speaking to clients over and over again about investing, one starts to get a sensation of what their expectations for their investments are. It is true that as time changes, differing economic circumstances create situations whereby the opportunities in the market morph and change. Something that most local investors can agree upon is their view that investments are merely some mirror of a higher interest paying term deposit whose capital appreciates or remains stable.

The lack of tolerance towards price fluctuations, and how the market forces impact the value of their assets and income, are two arguments which we grapple with every day in our sector, whilst trying to drive this message home. Investment advisors today have become this force that rationalises consumer expectations, and adapts investors to the market’s reality. Local investors with decades of experience have endured years of bell-weather and years of crises, and over the long haul have generated positive excess returns, whether they were conservative or more risk-loving investors.

In the years past the financial crisis we have seen major central banks in major developed countries ease monetary policy, with the objective of stimulating the real economy. The objective of this easing was to increase the levels of borrowing and investment into the economy. Depending on your view point you may argue that this has re-ignited the economic engine after the doldrums of the financial crisis, or you may believe the economy would have picked up from the lows of the financial crisis nevertheless. Regardless what your opinion on this subject matter is, the flipside to such policy has been the decrease of base interests across major economies.

Further central banks’ measures, dubbed as quantitative easing, launched by those of governments in Japan, the United States, the Euro-zone and the United Kingdom, injected billions in the respective currencies through open market operations, whereby sovereign bonds and high-quality corporate bonds were purchased in a bid to further stimulate their respective economies. The down-side to what can be possibly described as the greatest international exercise in monetary policy was the crowding-out effect, as investors dependent on yield were crowded out by central bank policy.

The current outlook for investors investing new money, or rolling over their investments both locally and abroad, has become that of low returns from asset classes, which previously provided a stable return with a relatively low level of risk. These effects have reverberated across banks, pension funds and outright individual investors who found themselves pushed out of the comfort of decent-yielding quality instruments into risker asset classes. Over the recent years, we have witnessed a shift of funds, moving into areas such as high yield debt, emerging market debt, equities and alternatives. This shift provided investors with higher yields, although the level of returns has also decreased due to a crowding out effect of more money-chasing the same asset classes. This consolidated a chain effect whereby the investors who previously used to participate in the higher yielding, higher risk markets, also got crowded out. In response, they have sought more previously remote areas of the market, and increased investor sophistication in their bid to generate yield and alpha.

However, despite this movement in the investment food chain I have just described, one needs to set back and assess the underlying risk that this implies to this new market eco-system. In the years following the crisis, as more money piled into virtually all asset classes, and the underlying assets and economies revved back to life, all asset classes benefitted from an inflation in asset prices, despite the falling yields. The question we need to pose ourselves today is:  what will happen in the cycle, where after a period of expansion economies start to normalize, or in some cases slow down their growth levels, as we have started to witness in the previous two years?

The main consensus surrounding the markets is that despite that the current market valuations are at historic levels, financial ratios indicate that the market may still have further upside. This is because key metrics in the US indicate that price levels stand slightly higher compared to their historical averages, but not at their highest levels. Elsewhere, such as in Europe, valuations remain depressed with potential for upside as markets have not yet experienced the sort of economic expansion witnessed in the US. In terms of fixed income, despite some increases in the returns in the US treasuries and corporate bonds, the yield picture for developed markets’ fixed income investors remains stubbornly low. During last year we got a glimpse of what could happen when negative sentiment, and volatility emerge, fueled by concerns over monetary policy and growth prospects.

The lesson to be learned from last year’s warning shots were first that diversification in such an environment is the only way to mitigate the downside risks of potential adverse market movements. The second lesson is that risk adverse investors should reduce their risk positions, built in the previous decade in their pursuit of yield, to avoid possible downsides that may lie ahead through monetary policy normalisation. In the name of capital preservation, accepting lower yields on capital through investing in higher quality assets may avoid investors having to endure asset price corrections. How long this environment could last will ultimately depend on what is in store for the global economy in the coming months, which will set the script for the years to come. The phrase lower-for-longer remains relatively valid in this period of transition, from ultra-loose monetary policy to a tighter regime. Investors should always understand that investments are not a static term deposit that requires no monitoring, but need professional attention to reach the best outcomes.

This article was prepared by Daniel GauciHnD Management, CeFa Investments,Investment Advisor at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]; https://www.jesmondmizzi.com