Equity prices have come to be detached from economic reality following the massive liquidity injections by states and central banks. This is causing a massive dilemma for wealth managers.
William C. Dudley has seen many crises come and go during his four decades in banking. Today though, the situation seems to have become so unsettling that the ex-Goldman Sachs banker and former governor of the Federal Reserve Bank of New York chose to come back out of retirement.
Before the U.S. central bank decided on its future monetary policy on Wednesday – which in the event was a decision to keep the rate at 0.25 percent and to maintain it there until 2022 – the economist suggested to his former colleagues to mind the «moral hazard». By preventing the financial system from collapsing time and again, and injecting untold numbers of dollars, the monetary authorities risk prompting the pros to take ever higher risks, he suggested.
The Crash Now Seems But a Distant Memory
The stock exchange currently resembles a giant casino. The share prices have surged as if there hadn't been a lockdown that has led to a demand shock and that will affect business – the real economy – going forward. Since reaching a low in March, the U.S. leading index S&P 500 has added more than 34 percent, almost paring the losses from the corona crash.
The euphoria that took hold of stock exchanges comprises an additional hazard that may prove decisive for the work of wealth managers though. The equity surge may be read as an escape out of bonds and into stocks. Which, put bluntly, means a shift into higher risk.
Distortion of Allocation
Thomas Steinemann, chief investment officer at Bellerive Privatbank, said: «Monetary policy in recent years has led to a distortion of allocation into risky investments. In Switzerland, investors are being driven by negative interest toward aggressive investments, just making sure they don't buy Swiss francs.»
With the reaction by central banks to the pandemic crisis it seems a pregone conclusion that rates will go even lower and returns on bonds deeper into negative territory. That puts an even bigger questionsmark over the share of bonds in the portfolio of asset managers. The «Financial Times» (behind paywall) raised the question recently whether the times of portfolios with 60 percent in bonds and 40 percent in stocks was over. And indeed, it makes little sense why securities that carry a negative return should make up a lions share of a portfolio.
A Turning Point
For wealth managers in the world's largest offshore market – Switzerland – this may turn into a historic turning point. Assets managers in Switzerland typically aimed at preserving wealth rather than achieving the highest possible return – and hence bonds held unparalleled significance. Pension funds still have set guidelines on the share of bonds that they need to keep.
Bellerive by contrast for years has been investing its clients' assets in equities only and is holding volatility derivatives as a means to stabilize the portfolios instead of bonds. «It is surprising to see why there isn't more investment going into volatility, which is to be had almost for free and inexhaustible thanks to the ups and downs on the market, like a tidal power plant,» said its investment chief.
Competition Left Behind
For the time being, most players will stick to allocations established over decades. But falling interest rates suggests even lower returns on bonds, but price gains for those who have stuck to the titles. And the big institutional investors are forced to stick to bonds in any case.
Staying put is a costly exercise though. Ipek Ozkardeskaya, an analyst at Swiss online bank Swissquote, describes a precarious situation. If you don't trust the surge in equity prices, you risk being left behind. As long as the illusion holds that everything is fine despite the crisis and that prices can only go up, the bull market gets reinforced. With the consequence that prices keep rising until the onset of the next crash – and the next central bank intervention. Ex-central banker Dudley would feel vindicated.
