How long does it take to avert a crisis? There seems to be an unwritten rule among negotiators and emergency planners that it requires 11 hours – at least some of which must be spent waiting for a transatlantic phone call and a pizza delivery. Nothing ever comes of third- or ninth-hour talks, does it?
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These conventions have been observed during most geopolitical crises, ever since Ronald Reagan and Mikhail Gorbachev spent 11 hours in a room in Iceland discussing “Star Wars”, the US strategic defence initiative, in 1986.
So, just a few weeks ago, with European governments facing a continent-wide sovereign debt crisis, it was perhaps inevitable that reports of the ensuing €750bn ($925bn) rescue plan cited “11 hours of talks” and some improvised catering at what “was meant to be a two-hour meeting”. In the early hours of May 10 emerged yet another 11th-hour compromise.
But portfolio management cannot always operate to a similar timetable.
After a 48-hour rally, the FTSE Eurofirst index has fallen since the bail-out was announced – leaving wealth managers reconsidering some of their asset allocations.
“For the first time, the politicians moved ahead of the market,” says Cesar Perez, chief investment strategist, EMEA, at JP Morgan Private Bank. “€750bn takes out the funding needs of Ireland, Spain and Portugal for the next three years. So the bond vigilantes should step aside for a bit … but now the governments need to implement the necessary reforms.”
Yves Bonzon, his counterpart at Pictet private bank, agrees: “I think we’re certainly past the worst.”
But can it get any darker before the dawn? “It is not as catastrophic but, from the point of view of investors, [the rescue plan] will just entrench the view that the financial crisis has not gone away,” says Bill O’Neill, chief investment officer at Merrill Lynch Wealth Management. “It will deepen caution.”
Peter Lees, head of equities at fund management house F&C, predicts some will use the bail-out as an opportunity to reduce their equity allocations. “The immediate reaction was positive, with equity markets soaring the day after it was announced, but re-evaluation is essential, given the heightened risks emerging from the EU. The question now is whether the positive response to the rescue deal is an opportunity to reduce risk, or will the bull market now resume?”
His colleague Ted Scott adds: “Any substantial rally should be used as an opportunity to reduce risk or sell.”
But with the only certainty being that “interest rates are going to be low for longer”, according to JP Morgan’s Perez, the next question is: what is a low-risk alternative to cash? “The sovereign debt crisis has affected markets in ways not seen in the past,” says Bonzon.
Hywel George, partner at Integral Asset Management, agrees. “The sovereign debt crisis is a clear warning to investors that government bonds, which have previously been viewed as low-risk investments, are rapidly becoming high risk. This is a particular problem for many private client portfolios that tend to hold large positions in UK gilts.”
Portfolios that used passive bond tracker funds have already experienced this problem. Managers are being asked to find alternatives to fixed income. “Clients have been trying to buy higher yield, [such as] emerging-market debt and dividend stocks,” says Perez. “A bit more than a third have left money market funds. Looking for yield is here to stay.”
At Pictet, emerging-market debt is also favoured, for the “combination of attractive yields with structural exchange rate appreciation”. Bonzon sees emerging-market currencies driving asset allocations for some time to come. “Where the tectonic shift is happening is the currency side,” he says. “That’s where people are taking action, and it’s one-way action ... This shift away from an equity-centric portfolio for the non-euro investor has only just begun.”
Where equity exposure is being maintained, it is with protection. “What this volatility is creating is the opportunity to go back into equity markets through structures with some protection on the downside,” says Perez. Ironically, he notes the post-bail-out volatility is helping to price the derivatives that can provide this insurance. At times like these, it is only options traders who can say: “Crisis? What crisis?”
"... government bonds which have previously been viewed as low-risk investments, are rapidly becoming high risk." That's the problem!
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