• Share markets were mixed over the last week with Eurozone shares up on the ECB’s monetary easing and talk of a ceasefire in Ukraine, Japanese and Chinese shares up but US shares down partly on worries that strong data might bring forward a Fed rate hike and Australian shares down. Bond yields mostly rose, but yields in peripheral Eurozone continued to slide. The ECB easing saw the euro continue to slide with the rising $US weighing on commodity prices, but the $A remaining stubbornly strong despite a sliding iron ore price.
• ECB announces quantitative easing (QE). In response to poor growth and the rising risk of deflation the ECB eased more than expected in announcing a 0.1% cut to its official interest rate taking it to just 0.05% and that it will begin buying asset backed securities with the aim of expanding its balance sheet by €1 trillion. The ECB won’t announce the details of its asset buying program till next month, but by indicating it will include mortgage backed securities and covered bonds it has effectively allowed a much larger scale program. It’s not US style QE as the ECB will not be buying government bonds (at this stage anyway), but it will have the same effect in pumping cash into the economy, displacing investors from relatively low risk investments and forcing them to take on more risk which will lower the cost, and improve the availability, of funding throughout the economy. And its latest rate cut will lower the cost of cheap four year funding for the banks to just 0.15% pa. Will it work? It will certainly help, particularly all the talk of money printing will head of a deflationary mentality taking hold.
• Ukraine is not over yet. While there was a bit of hope regarding a possible cease fire in Ukraine, this may be Russia’s attempt to look constructive ahead of a NATO summit. At this point the two sides still look far apart and so it’s too early to get optimistic. There are essentially three scenarios worth considering for investors regarding Ukraine. First a peaceful resolution soon, which would probably see Ukraine stay out of the EU and NATO to appease Russia. Second, an escalating war between Ukraine and Russia. Third, an escalating war that draws in direct military involvement from the West led by the US and Europe. Of these: the first would be a minor positive for global share markets but would quickly be forgotten; the second would be a source of volatility but like now would only be a major issue if sanctions get ramped up, but would ultimately not derail the global economic expansion; and the third would be a major concern for the global economy and hence could see a sharp fall in share markets. However, the chance of third scenario occurring – ie direct conflict between the West and Russia occurring is very low. The West may respond with escalating sanctions and NATO sabre rattling but it’s very unlikely to engage in anything approaching direct conflict with Russia for the same reason it didn’t through the Cold War (ie Russia is a nuclear power). So we remain of the view that Ukraine will likely remain a source of uncertainty for investors (and slower growth for Europe), but it’s unlikely to derail the global economic expansion.
• In Australia, there was nothing new from the RBA which left interest rates on hold for the 13th month in a row and reiterated that a period of stability remains prudent with this message effectively backed up by a speech by Governor Stevens. Right now the uncertainty around the economic outlook and the strong $A preclude any thought of a rate hike, but by the same token signs the economy is responding to lower rates and the risk of boosting financial risk and house prices preclude rate cuts.
• Meanwhile, there seems to be lots of doom and gloom on Australia lately with talk of the economy in the “danger zone” and even ads on my iPad apps screaming “Australian recession 2014 – why it’s unavoidable…” This is way over the top! Sure the fall in commodity prices and specifically the iron ore price is a blow to national income. But thankfully lower interest rates are helping to drive a bounce back in the sectors of the economy like housing and retailing that were suppressed by the mining boom. And there is still plenty of scope for interest rates to fall further if needed and for the Australian dollar to fall, which I think it will over time, providing a shock absorber for the economy. But the real story on the Australian economy – as evident in the data seen over the last week – is that the shift back to a more balanced economy is proceeding.
• It’s been a somewhat messy week for policy making in Australia. The mining tax hit the dust, but the increase in the super levy has been delayed yet again, leaving likely super retirement savings inadequate for most workers needs and there’s talk of a fund to bailout failing companies. While the latter is nice in theory, in practice such government intervention rarely works, so hopefully the Government will reject it.

Major global economic events and implications

• US economic data was pretty solid with the ISM indexes rising to very strong levels, construction activity and auto sales rising solidly and labour market indicators remaining strong. This is all keeping alive the prospect of a Fed rate hike coming earlier than mid next year.
• In Europe, economic news was mixed with a downwards revision to August PMIs albeit to levels still consistent with modest growth but a sharp rebound in German factory orders.
• The Bank of Japan made no changes to its super stimulatory monetary easing program. But there was good news on the economic front with nominal cash wages up 2.6% over the year to July suggesting wages growth and inflationary expectations are responding to the BoJ’s campaign to end deflation.
• Chinese economic data was mixed with the manufacturing conditions PMI for August falling back a bit, but services conditions PMIs strengthening suggesting that overall growth remains okay.

Australian economic events and implications

• The avalanche of economic data in Australia over the last week painted a reasonably hopeful picture for the economy. Sure the ongoing slide in the terms of trade is a blow and growth slowed in the June quarter, but the growth slowdown was nowhere near as bad as many feared and there are clear signs of improvement in the non-mining economy. Given that the main reason for the slump in quarterly growth from 1.1% in the March quarter to 0.5% in the June quarter relates to volatility in exports and imports it makes sense to average the two quarters which gives 0.8% quarter on quarter or 3.2% annualised, which is a pretty good outcome given the circumstances. More fundamentally, July data for retail sales point to a bounce back in consumer spending growth in the current quarter, the trade deficit also improved in July suggesting that net export volumes are likely to bounce back and continued strength in building approvals points to ongoing growth in dwelling construction.
• The June quarter National Accounts also included a couple of long term positives for Australia. First, productivity growth is solid at 3.2% year on year in the market sector, which will help minimise the hit to living standards from the fall in the terms of trade. Second, the household saving rate remains strong at 9.4% indicating households have a good buffer against shocks to income and are continuing to improve their net debt position.

What to watch over the next week?

• In the US, August retail sales data (Friday) are expected to show modest growth after the disappointingly flat outcome for July. This is likely to be supported by a further lift in consumer confidence (also Friday).
• In China, the focus will be on data releases for August. Expect trade data (Monday) to show exports up 10% and imports up 4%, lending and credit data to show a bit of a bounce back after weakness seen in July, CPI inflation (Wednesday) falling back to 2.2% year on year and slight moderations in growth for retail sales, fixed asset investment and industrial production (Saturday).
• In Australia, expect ANZ job ads (Monday) to show a further trend gain, housing finance (Tuesday) to rise 1%, the NAB business confidence and conditions measures (also Tuesday) to remain around the reasonably solid levels seen in July, consumer confidence (Wednesday) to show a further slight improvement and employment to show a 10000 gain with unemployment falling back to 6.3% after July’s partly statistical spike.

Outlook for markets

• While shares have seen a strong recovery from the early August mini-slump, the correction season consistent with the old adage “sell in May, go away and come back on St Leger’s Day” is still upon us with September historically being the weakest month of the year for US shares and the September-October period often being tough in Australia.Relatively high short term optimism readings in the US also warn of the risk of a correction and there is no shortage of potential triggers including worries about the Fed and Ukraine.
• However, despite the risk of another correction the cyclical bull market in shares likely has a lot further to go as we still don’t see the signs of shares being over valued, over loved and over bought normally seen at major market tops.Valuations remain okay particularly once low interest rates and bond yields are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, monetary conditions are set to remain easy for some time and there is no sign of the euphoria that comes with major share market tops. In fact, in terms of the latter there still seems to be a lot of wariness regarding shares.
• Low bond yields, eg 10 year yields of just 0.5% in Japan and 3.4% in Australia, will likely mean soft returns from government bonds.
• The combination of soft commodity prices, the likelihood the Fed will start raising interest rates ahead of the RBA and relatively high costs in Australia are expected to see the broad trend in the $A remain down. Expect to see $US0.80 in the next few years, but getting the timing right is hard.

By Dr Shane Oliver, Head of Investment Strategy & Chief Economist, AMP Capital

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Important note:While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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Assessing risk is one of the key factors in the investment process since every investment involves some level of risk. Most investors consider medium to high probability risks when making their investment choices. Low probability risks tend, perhaps understandably, to garner less attention. However, in our view, considering the impact of a variety of risks is crucial for effective risk management. It is important not only to consider high probability risks, but also low probability ones, especially where they would have a serious negative impact. This is a lesson that many investors learned when the GFC occurred and they were taken unawares.

Bonds have started to fall out of favour as investors are worrying about the end of the bond rally and rising interest rates in the medium term. However, were a low probability, high impact risk to occur, then it’s important to maintain an allocation to bonds in a diversified portfolio. If investors had had a higher allocation to traditional defensive Australian fixed income funds during the GFC, their portfolios may have been better protected. Fixed income provides superior volatility-adjusted returns (return per unit of risk) than equities, which has benefited fixed income investors during economic downturns.

In this paper, we discuss three low probability, high impact risks that Tyndall AM has been factoring into its thinking about the global macroeconomic landscape. We emphasise that we believe these events are unlikely to occur, but that the fallout if they did could be extremely severe. In such a situation, the portion of an investor’s portfolio allocated to bonds could help cushion the overall portfolio losses on the equity portion.

Is there a Canadian housing bubble and what would happen if it pops?

Interest rates across the world are at record lows and major central banks are indulging in huge quantitative easing (QE) policies. This has created a large amount of money that needs to be deployed. Following the GFC, banks globally have been reluctant to lend, particularly to small and medium-sized businesses. However, in some countries that came through the GFC relatively unscathed, banks have been willing to lend to individuals, in particular to invest in real estate.

In Canada, the household debt to GDP ratio has been steadily rising, such that it now stands at almost 100% of GDP (see chart 1). According to the World Bank, the increase in this ratio since 2006 has been faster in Canada than any other country.

This phenomenon seems to be driven heavily by mortgage borrowing, which would explain the hefty rise in house prices over the same period (see chart 2).

Countries that suffered severe housing market over-pricing in the lead up to the GFC, such as the US and Ireland, saw a strong correction and haven’t recovered much since then. As a result, those countries are now slightly undervalued. Countries that weathered the GFC more successfully are now the ones facing potential housing bubbles. As chart 3 shows, Canada was second only to Norway in that list as of the end of 2012 and Canada’s house prices are more than 60% higher than their long-term average. The Organisation for Economic Co-operation and Development (OECD) has ranked Canada as one of the countries most at risk of a price correction, especially if borrowing costs increase or income growth slows.

Due to its well-regulated financial system and fairly solid banks, Canada has been seen as a relative safe-haven following the GFC, attracting significant foreign capital inflows. Former Governor of the Bank of Canada (now Governor of the Bank of England), Mark Carney sounded the warning bell over using these foreign capital inflows to inflate the housing market rather than putting it towards business initiatives. He said that it was like a film that has “just played in a major cinema just south of here, over and over and over again, and it would be the height of folly to repeat those mistakes.” 1

Construction projects are booming in response to demand from investors and home buyers taking advantage of record low interest rates. But analysts are warning that Canada’s housing market is due for a correction due to this overbuilding, as well as overvaluation and excessive household debt. The Bank of Canada recently noted: “The elevated level of household debt and stretched valuations in some segments of the housing market remain an important downside risk to the Canadian economy.” 2

The immediate impact of a major housing market correction would be on the Canadian banking system. However,

Canada’s banks remain relatively strong and although a slump in the housing market could create difficulties for the smaller banks, it is unlikely to have the same deadly impact in Canada as the slump in Irish property had on banks in Ireland. In addition, although Canadian banks extend globally, especially into Latin America and Asia, they are still minor players compared with major US or European banks so the knock-on effects would be more muted.

For Australian banks, the direct impact would likely be limited given that their exposure to Canadian banks is relatively low. However, the similarities between Canada and Australia could cause a severe weakening of sentiment towards Australian banks if their Canadian counterparts were to stumble. In such a case, the Australian banks’ dependency on offshore funding for a substantial part of their balance sheet could become a pressure point and the cost of funding could become elevated. Although it’s unlikely that this alone would be sufficient to cause major disruption in the Australian banking system, it could affect the credit spreads on the banks’ bonds and lead them to underperform for some time.

What are the downside risks for China?

China’s economy is no longer seeing the stellar growth that it had become accustomed to. The consensus view is that the country is unlikely to suffer a hard landing. While this is the most likely scenario, there are several issues about China that concern us: its shadow banking system, the extent and size of which is staggering; property prices in the major urban centres, which are displaying bubble-like conditions; and local government debt levels.

Shadow banks issue liabilities and hold assets, much like normal banks. However, unlike banks they lack an official lender of last resort. The International Monetary Fund (IMF) has pointed out that “a fast-growing share of credit is flowing through the less-well-supervised parts of the financial system.” 3   In fact, JP Morgan Chase & Co. estimates that from 2010 to 2012, shadow lending doubled to an estimated 36 trillion yuan or about 69% of China’s GDP. 4 The vast proportion of shadow banks’ business involves wealth management products (WMPs), which raise money from investors in large increments and for short periods. The problem with WMPs is that they have a potentially risky duration mismatch with the long-term underlying illiquid assets (such as property) they are secured against. The other issue is that those assets are not usually disclosed to investors so that they have no idea what they’re investing in. Often the banks repay maturing WMPs using money raised from new WMPs, which creates huge risk if the underlying assets were to perform poorly or default.

Another concern with shadow banks is that they are deeply intertwined with the commercial banks, which means there could be a knock-on effect if any of them fail. Shadow banks have sprung up because of the official policy of financial repression, where interest rates have been held at artificially low levels for a very long period to enable banks to keep lending to enterprises and governments, especially those engaged in building infrastructure. This drives Chinese households into WMPs in search of yield above the sub-inflation rates they are offered on bank deposits. The problem is that if enough of the riskier WMPs fail, investors might stop buying new products. Given the short-term nature of the WMPs vs. the long-term nature of the underlying assets, it could lead to a credit crunch on otherwise solvent projects.

The housing bubble issue is related to that same search for yield. China has very few investment vehicles on offer and real estate is one of those few. Prices continue to rise as a result, particularly in the larger cities, such as Shanghai, Shenzhen and Beijing. However, the pace of building may be starting to outstrip sales, particularly outside the larger cities where there is a growing stock of completed but unsold homes. The government has tried to curb this appetite for real estate, but with economic growth weakening it can’t risk leaning on the housing market too hard while it remains an engine for growth. Another concern is how indebted the property developers are, which makes them vulnerable to any downturn.

In December 2013, China announced the results of a debt audit on local governments, which included contingent liabilities and debt guarantees. The audit revealed that liabilities of local governments totalled 17.9 trillion yuan as of the end of June, compared with 10.7 trillion yuan as of the end of 2010, a 67% increase.5 Local authorities have been using debt to fuel growth, channelling money into infrastructure projects, some which may not have been particularly viable. However, given that the debt is almost all denominated in the domestic currency (yuan) and owned domestically, the central bank can prevent a crisis by deploying its unlimited liquidity supply.

The Chinese government realises that growth via such an investment-based economy is unsustainable. As a result, it is attempting to shift growth away from fixed asset investment towards domestic consumption, but this rebalancing is a delicate task. 2013 has seen repeated bouts of stress in China’s money markets as the government has attempted to tighten monetary conditions and reduce the economy’s reliance on cheap capital. By raising short-term rates and making them more volatile, the government is encouraging banks to stop relying on short-term liabilities in the interbank market to finance risky longer-term assets. Although the government doesn’t want to see a severe cash crunch, a miscalculation is possible if it doesn’t correctly predict the supply of and demand for cash when conducting monetary tightening. China needs to reform its financial sector, rein in government debt and increase consumer spending all at the same time – not an easy task.

Given how much control authorities have over the economy, for a crisis in China to emerge, it would likely be an accident, the result of an underestimation by authorities of the magnitude of one of these three issues and letting it get out of control.  Any resulting slowdown would threaten stable growth in other economies. Australia in particular would be hit extremely hard by a crisis in China, so although such an occurrence might be extremely unlikely, it must be a factor in Australian investors’ thinking.

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Investors looking at their medium-term and long-term investments are currently asking themselves: what is in store for bonds when rates normalise? As central banks’ bold experiment in monetary policy comes to an end and they begin to normalise cash rates, many investors fear possible negative returns on bonds, such as we had in 1994, which is notorious as the year of the great bond rout. Either we will see an orderly bond selloff (with a slow, steady rise in yields) as the central banks successfully manage to exit quantitative easing (QE) without causing market panic, or we may experience a disorderly one if central banks lose control of the process. Another possibility is that there is a selloff caused by inflationary fears. Whichever scenario one subscribes to, the outlook for bonds does look risky.

Obviously with any asset class, investors must ask the question: does the cost of holding bonds outweigh the benefits of holding bonds? In our view, the answer is no. Bonds remain an important component of a portfolio: even in a rising cash rate environment, diversifying a portfolio so that it includes fixed income alongside other assets can help balance returns, diversify risk and reduce overall volatility. The approach should not be to avoid or sell out of bonds, but to look at the types of bonds in a portfolio and to adopt a flexible, active approach that helps cushion the bond portfolio against rising rates.

Bonds are the only truly defensive asset

Over the past few decades, Australian investors have largely ignored fixed income investments, preferring cash or term deposits as the defensive assets in their portfolios. Although they believed they were investing in asset classes which were getting higher returns, actual returns were higher for true fixed income funds since cash and term deposit holdings missed out on the capital returns enjoyed by bonds.

In addition, these investors missed out on the major benefit of holding high quality bonds – the negative correlation they provide to equities. Although bonds don’t generally deliver the high returns that equities do, holding them in addition

to equities should decrease the risk in a portfolio. In market environments when equities are performing poorly, the bond holding can help to offset losses on the equity portion. So it’s possible to construct an efficient portfolio that maximises potential returns while helping to minimise risk. This cannot be done with other defensive asset classes, such as cash or term deposits, because their correlation to equities is zero and can even verge on positive in the long term since falls in equity markets can lead to cash rate cuts by central banks.

Bonds tend to perform relatively better in market downturns and when, due to very low inflation or deflation, prices are falling. Although bonds may perform well during times of low inflation or deflation, such an environment is bad for most other asset classes, particularly equities. Central banks around the world have strived for low inflation, but the risk from any cyclical fall in inflation can lead to a deflationary scare in financial markets, such as we saw in 2001 and 2009.

The reason why we have seen such a bold QE experiment by central banks is that they have learnt how to deal with inflation and have the tools to do so. However, most have not had to deal with deflation and don’t necessarily have the tools to handle such a scenario. Japan in the 1990s and the US in the 1930s are examples of the risk of deflation and the difficulty it takes to get out of such a situation once in it. With low world inflation and the weakening of conventional monetary and fiscal policies, deflation is still a potential risk for investors to consider, just as inflation was in the 1970s and 1980s. Maintaining an allocation to bonds would help to offset this risk given their superior performance in such an environment. Cash and term deposits would not offset the risk of deflation because the RBA would cut the cash rate to very low levels in order to try to jump-start the economy in that scenario.

Assessing risk for bond portfolios

The short-term risk of higher rates is compounded by the current relatively low yields and the fact that duration has increased for bonds and the typical benchmarks. The lower a bond’s duration, the lower its price volatility and the less sensitive it will be to interest rate changes. The duration of the UBS Composite Bond Index 0+YR (the benchmark for most Australian bond funds) is currently around four years compared with three years prior to the GFC1. The major reason for this is that government issuance since the GFC has tended to be longer in nature. For example, Australia issued a 20-year government bond in November, the longest maturity bond to be issued since the 1960s.

Apart from duration, it’s important to consider what will happen to bond yields when assessing what a rise in rates will do to bonds. The most important consideration is when and how orderly, or disorderly, the bond selloff is. If rates were to rise and bond yields rose in an orderly and steady manner, they wouldn’t suffer large losses. However, in a disorderly selloff or market panic, it’s possible that we could see negative returns, as in 1994. The big risk to bonds isn’t so much rising rates, it’s rapidly rising rates. A fact that might surprise some investors is that in the past 20 years, Australian bonds have only experienced negative returns twice, in 1994 and 1999. Although 1994 saw a very disorderly selloff in the bond market, it only delivered a negative return of  4.66%, with -1.22% for 1999 . The most common returns over the whole 20-year period have been between +5% and +15%.

In addition, unlike capital losses experienced on equities, capital losses on bonds are recovered over subsequent periods until maturity. This is called the ‘pull-to-par’ effect: As a bond approaches maturity, its market value gets closer and closer to its face value based on an assumption by the market that the bond will be repaid in full and on time. Even if rates do rise and prices fall, as long as the issuer remains solvent, investors will receive repayment of their full capital investment at the bond’s maturity. So, if you hold a bond until it matures, you won’t lose your principal. The potential for capital loss thus only comes when selling a bond before it matures or if the issuer defaults.

New natural rate of interest is around 4%

Quantitative easing from global central banks has depressed real rates and term premiums. The chart below shows how we believe the new natural interest rate (NRI) has changed from being around 5-5.5% from the start of the century until the GFC, to around 4-4.5% since then. In our view, the reasons for the drop are pressure on the government to rein in spending and that since the Reserve Bank of Australia (RBA) started cutting the official cash rate, Australia’s banks have retained around 100 bps of those cuts and not passed them on.

Source: Bloomberg

If rates were to normalise, we should expect the cash rate to head toward this new NRI, so potentially the extent of the rise over time would be around 150-200 basis points (bps). Obviously, the NRI can change temporarily, but this means the extent of the selloff shouldn’t equate to 1994.

In our view, the concept of duration should be rethought, particularly as it applies to individual bonds. As a measurement of risk in a portfolio, duration is still highly relevant since it measures the portfolio’s sensitivity to interest rates. However, that does not mean that long duration bonds are necessarily more risky – as the chart above shows, 10-year bonds are currently within the 4-4.5% band of this new NRI. If long-term rates don’t move or don’t move by too much, then longer duration bonds shouldn’t be particularly affected. If we saw the cash rate rise to 4.0%, then it would be the yield on the shorter maturity bonds which would react the most and despite their shorter durations, they would suffer worse losses than higher duration bonds. Longer duration bonds are more vulnerable to central banks decreasing their purchases or decreased foreign investment in Australian bonds as the supply increases. However, a normalisation of cash rates would not hurt all maturities of bonds equally.

Because a bond portfolio comprises a variety of bonds with different interest rate levels and maturities, it should have a steady stream of maturities which can be invested at the higher yields if cash rates/yields are rising. By owning bonds of different maturities, fund managers ensure that they are not tying up money for too long. If and when interest rates go up, maturing assets offer the opportunity to reinvest that capital into more recently issued, higher yielding bonds. As such, the effect of any return erosion is constantly being reduced and so any capital losses on bonds should be recovered over time. It’s important to remember that not all bonds are the same: a diverse portfolio containing different bond types and maturities helps to minimise any potential losses.

Conclusion: Bonds remain a good long-term investment

Bonds remain a viable asset class despite the risk of higher rates in the short term. Apart from bonds’ defensive qualities and negative correlation to equities, the longer term threat of deflation and the impotence of central banks to deal with it also warrants an allocation to bonds. The question is which bonds to invest in and at what level. Good value can still be found in various areas of the bond market, such as semi-government, bank and some corporate bonds, as well as by using duration and yield curve strategies. Opportunities remain to add value through bonds via active management using a variety of different strategies in combination to produce a diversified, well performing portfolio.

By Roger Bridges

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“Tyndall AM”). Tyndall AM is part of the Nikko AM group. The information contained in this document is of a general nature only and does not constitute personal advice. Nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The information in this document has been prepared from what is considered to be reliable information but the accuracy and integrity of the information is not guaranteed by the Company. Figures, charts and other data, including statistics, in these materials are current as of the date of publication unless stated otherwise. In addition, opinions expressed in these materials are as of the date of publication unless stated otherwise. The graphs, figures, etc., contained in these materials contain either past or backdated data, and make no promise of future investment returns etc. Past performance is not a reliable indicator of future performance.

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The enormous injections of liquidity via quantitative easing (QE) has created a financial ‘Waterworld’, flooding the global monetary system and significantly altering the investment landscape, according to Investec Asset Management Global Strategist, Dr Michael Power.

Dr Power, who is visiting Australia this week at the invitation of Investec Bank (Australia) Limited, presented an analogy with the 1995 Kevin Costner film, Waterworld, where humans were forced to navigate a submerged world.

Dr Power believes the almost limitless liquidity injected to the global monetary system has melted the monetary ice-caps, in the process destroying the traditional risk-free rate investing anchors – or “dry-land”.

“The concept of risk free investing, where capital invested earns a positive after-inflation return has underpinned fixed income and equity investing in the Western world over the last three decades,” Dr Power said. “However, the liquidity injection of central banks has moved developed markets interest rates underwater, sinking many safe haven returns below inflation.”

Expanding balance sheets

Dr Power explained that the ‘Waterworld’ has been created by the dramatic expansion of central bank balance sheets as governments around the world have taken on further debt since 2008. At the same time, the populations of developed economies of the West and Japan continue to age.

“Quantitative easing, in effect, is a frantic effort by Western and Japanese authorities to stop the natural deflation of their economies as the population ages and the size of their workforces start to shrink as a percentage of total population,” Dr Power said.

“Were technological advances and hence productivity so profoundly positive as to offset this demographic drag, economic growth would remain healthy. However, this does not seem to have been the case and Japan in particular has now endured two lost decades of growth and the question on where to invest is becoming more difficult to answer,” he said.

Where to find dry land?

Dr Power believes that the ultimate destination for capital is “dry-land” – in other words, new safe havens offering new risk free rates with real yields that reset the foundations upon which to base both fixed income and equity investment decisions.

According to Dr Power, the challenge for investors as navigators of capital will be to first preserve capital, navigate macroeconomic headwinds, and set course for emerging opportunities.

“As asset managers, we must see ourselves as the navigators of capital, unanchored from the traditional certainties of a positive-yielding risk-free rate. Our challenge is to choose the appropriate vessel, ensure capital is preserved and deal with the structural changes caused by central bank liquidity as new anchor points emerge,” said Dr Power.

He said many of the anchors will be located in emerging markets, and that inflows to Asian currencies already reflect this changing landscape.

“We believe safe havens should offer investors a risk free real return, not a return free risk, which is becoming increasingly difficult to find in developed markets,” he concluded.

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