Portfolio agility required in a changing world (afr.com)

Holding liquid assets is hard to stomach when the return on cash is anaemic and the return on liquid investments generally comes at a discount compared with their unlisted counterparts.  However, investors always under-appreciate liquidity and portfolio flexibility until it is really needed.   

Since the Global Financial Crisis, policy makers have struggled to get economies moving up towards potential growth rates and have pushed a mix of quantitative easing (increasing system liquidity) and fiscal spending to boost activity and lift inflation rates into their target ranges.   The Covid pandemic has exacerbated these activities.  The overall impact of these polices has been to drive bond yields down across the world and generated previously unimaginable negative yields in significant swathes of the global bond market.

While consumer prices have been very soft for years, even despite pockets of tightness in labour markets, asset prices have skyrocketed.  House prices and infrastructure have enjoyed incredible returns. The chase for yield has pushed many investors to move out the risk spectrum – either taking on longer maturity fixed income investments, additional credit risk, or trading away liquidity by piling into unlisted assets such as private debt and equity, venture capital and unlisted infrastructure.  What we have seen is the illiquidity premium for investing in these assets has been crushed.   While there is still some pick up in return for locking your money away for extended periods of time, the true premium for doing so has been significantly reduced over the past few years.

The policy mix that has created these trends could be about to change.

The development of the vaccine and the opening of economies has seen economies rebound strongly.   Underlying price pressures have increased, and companies are complaining about the supply and cost of raw materials now impacting on production capacity and margins.  The shortage of semiconductor chips is a real case in point.   Global supply chains surety continues to be compromised by the threat of coronavirus-induced lockdowns, growing trade conflicts and populist trade policies.

Investors are following the language of central bank minutes and speakers closely with several central banks hinting of future policy changes.  Some central banks have already announced a tapering of their quantitative easing programs. The Reserve Bank of New Zealand now forecasts an interest rate hike in the second quarter of 2022 while comments out of the Bank of England suggested that rates could rise in early 2022. The US Federal Reserve Minutes released during May revealed that it would be appropriate “at some point” to discuss tightening its accommodative policy if economic momentum continued at its current pace.  This has been widely interpreted by investors as a flag that tapering may be discussed as early as July.   Managing the orderly withdrawal of the extraordinary stimulus in the system will not be an easy task. 

The unwinding of central bank quantitative easing policy over time will likely mean that bond yields will need to rise to a level that makes sense to a private sector buyer – a level that at least delivers a positive real rate of return.   Higher bond yields will put pressure on valuations in many inflated asset classes. 

Being liquid instantly becomes more valuable.

Volatility is likely to increase as markets adjust to a reduction in tailwinds and portfolios need to be adjusted.  Investors will need to stay nimble to opportunities as these processes are rarely straightforward.  Highly leveraged strategies suddenly come under stress and opportunities invariably arise.  Those that have chased yield through illiquid strategies may feel some pain as new opportunities that arise from market dislocation suddenly pass them by.

Of course, there is nearly always a role of patient capital in an investor’s overall portfolio mix.   There are decent benefits that come from investing in the more illiquid areas of private debt, private equity, and real assets over the cycle.   However, this cycle has been the most punishing in history on holding liquidity and many investors have reluctantly been forced into new sectors and strategies in search of return that they may not fully appreciate – particularly around liquidity and concentration risk.  Hopefully, when this cycle does turn, they are not ruing missed opportunities to move their portfolio mix around more freely.