Are we at the end of maximum liquidity?

Since the US first undertook Quantitative Easing (QE) in December 2008, the global financial system has been awash with liquidity with further rounds of QE from the Federal Reserve (Fed), the Bank of England (BOE) and Bank of Japan (BOJ) to name but a few over the last 7 years.

This additional liquidity has had a profound impact on asset prices with sovereign bond yields falling, to the lowest levels in history in some cases. The dramatic fall in yields meant that investors seeking income have been forced up the risk spectrum into investment grade bonds, high yield bonds and even equities in their search for yield. This “search for yield” has effectively quashed volatility and driven asset prices ever higher.

Given the benign environment following QE and ultra-low interest rates, investors are rightly questioning when this period of maximum liquidity might end. All eyes are on the Fed who have ended their QE programme after a period of tapering as investors look for some clue as to when the first interest rate rise in almost a decade might come. Expectations continually get pushed further out with consensus opinion now that the first rate rise will come around September of this year.

Now more than ever it is vital that investors are suitably positioned for future

Here in the UK, the recent Monetary Policy Committee (MPC) minutes gave a strong indication that they are expecting to raise rates at some point next year, despite inflation now being negative. Over in Europe the picture is radically different as the European Central Bank (ECB) has recently embarked on a massive QE programme of their own. Having driven down European government bonds yields in to negative territory in many cases, i.e. investors had to pay to lend governments money, a sharp reversal occurred in recent weeks leaving many bond investors nursing large losses.

Therein lies the rub. With diverging monetary policies around the world, we have already seen volatility rise meaningfully in asset classes which are traditionally viewed as the safest. As the Fed and BOE try to navigate the treacherous path out of the greatest monetary policy experiment the world has ever seen, the potential for errors and dramatic spikes in the market volatility is ever present.

Now more than ever it is vital that investors are suitably positioned for future volatility. The primary way that investors can mitigate volatility is to ensure that their portfolio is suitably diverse, holding a broad range of different assets which have a low or negative correlations. This portfolio should be designed to align with their individual risk tolerance and loss capacity over the long term.

For clients with actively managed portfolios an additional layer of defence is to invest with those managers who have demonstrated the ability to deliver attractive returns with consistently less volatility than their peer group. Advisers who are familiar with Parmenion will know that these principles lie at the heart of our investment philosophy and process.

Published on Wed 27th May, 2015 Written by Stephen Lennon of Parmenion Investment Management