|UK 7-10 Year Gilt Index
5. Why is this a good time to be aware of this issue?
In recent years, financial markets, both in the UK and overseas, have experienced a relatively favourable backdrop. The main reason for this has been a combination of improving economic news (admittedly it has varied by country), and accommodative monetary policies, including low interest rates. The result has been ample liquidity that has needed to find a home somewhere – and financial markets have been a prominent beneficiary.
In fact, since the 2008 global financial crisis, nine years of cheap money policies in the UK and most western economies have benefitted financial assets, including bond and stock markets. Now, this cheap money policy is being reversed, led by the US Federal Reserve, which has been raising rates for over two years. The Bank of England, meanwhile, hiked rates at the end of 2017 and again in August 2018. Although there are other issues (such as the trade war between the US and China, inflation, emerging market concerns) the reversal of monetary easing could expose the current high valuation of financial markets and lead to a major market correction.
6. Can we predict market corrections?
No, although it is possible to anticipate them. Markets can sometimes look overvalued based on a range of criteria. The challenge in predicting a correction is that if markets are overvalued they can overshoot and become even more overvalued before they correct. There is no evidence of active fund managers being able to predict a market correction on a sustained basis, as we explored here.
7. Whenever we hear of a market correction or a market crash it is always in relation to stock markets. Does that mean bond markets do not correct or crash?
No. A market correction can occur in any market. In currency markets we do not refer to it as a correction – a sharp fall there is referred to as a devaluation. In bond markets there can also be significant corrections. In fact, now is a good time to be aware of this. Since the late 1980s the UK government bond (gilt) market has enjoyed a sustained rally, with a long-term fall in yields. This bull market for gilts has, naturally, seen significant market corrections along the way. These are seen in terms of yields rising, as that is the equivalent of gilt prices falling. Now, yields are low but rising as official interest rates increase.
8. Is it possible for all asset classes to sell off together?
Yes, but it is not that common, hence the benefits of a diversified portfolio. Sometimes investors have a preference to be invested more in one type of asset versus another (say equities over bonds) as that fits their personal needs and expectation of the future. One can look at the correlation between different asset classes to get an idea of how they have moved together.
9. Does Brexit make UK assets more or less vulnerable in difficult times?
Brexit creates uncertainty during the exit process, as we are seeing, but once exit has occurred then the greater clarity should allow a firmer assessment to be possible. UK assets need to take into account not only the outlook but also recognise that the UK authorities have policy tools such as interest rates that can be used to stabilise the economy if needed, and thus impact the markets. Sterling, too, can be flexible.
10. Could UK interest rates fall if financial markets hit difficultly?
Yes, but we are not expecting rates to be cut. The Bank of England raised rates in August 2018 but they have taken into account different risks in making their decision. While they seem unlikely to cut rates they could always do so if there was a shock. Indeed at the IMF meetings in October 2017 in Washington one view among global central bankers was that they needed to raise rates soon so they could cut rates in a few years if economic conditions deteriorated.
11. As manager of my investment portfolio, what asset allocation steps are you likely to take in the event of a bear market?
Our investment approach is to try and mitigate prolonged periods of volatility by a strategic diversification across asset classes, regions and currencies. We also implement cyclical adjustments to portfolios with the aim of addressing specific economic concerns or market risks that may knock performance off-track.
12. What is the key takeaway from this article?
There can always be corrections. We should not be shocked if they happen or panic if they do. Clients should aim to choose the risk portfolio that best suits their needs and allows them to feel comfortable withstanding market corrections as and when they occur, rather than attempting to time the market, which evidence shows is incredibly difficult.
As always, we encourage clients and potential clients to contact us at any time if they are unsure of anything to do with their investments, would like more guidance or would like advice specific to their circumstances.
Please remember that when investing your capital is at risk.