Another remarkable week in markets has passed. Brexit fears faded further and risky assets performed well, while government bond yields remained remarkably low.
As a result, all major asset classes are now showing a positive total return since the beginning of June or even the day before the Brexit vote and, most impressing, global real estate is even up more than 7%. It might feel to some that we have started to walk on water in global capital markets, but it remains wise to first think through what happened recently before jumping to that intuitive conclusion.
The first thing to note is that we might not be escaping from the laws of nature, but are indeed experiencing a flooding of liquidity that is lifting all boats in global markets. This basically results from two major factors: cash-rich investors and (expectations of) central bank policy easing. The former seems to have created an unleash of pent-up demand for capital market exposure by investors that were both cautious and holding extremely high cash levels in the run-up to the Brexit vote.
The latter results from both the broadened QE effort of the ECB (into corporate bonds space from June onwards) and the anticipation of substantially less Fed hikes (if any) and more policy easing by the other major central banks over the next 18 months.
High risk premiums are hard to resist
The political crisis in the UK following from the Brexit vote is so far showing limited signs of either political or financial market contagion into the rest of the world. Combined with signs of policy easing on the investment radar, it is actually understandable that some investors have started to put their (clients’) money to work again.
This becomes even more obvious if one realizes that risk premiums outside of government bond space are still pretty high. Since the beginning of the century, it was only during the Lehman crisis and the peak of the euro crisis that our Risk Aversion Index, which captures a broad range of risk premiums in all market segments globally, stood at higher levels than in recent months. In a world where the alternative is negative yields on either cash or bonds, these levels of premiums are hard to resist for too long for investors.
And with the UK political uncertainty actually fading somewhat over the week (Theresa May becoming Prime Minister much faster than expected) and economic data actually improving recently (see Figure 2) it seems that some asset allocators have started to pull the trigger and are moving back into equity, credit and (listed) real estate again.
Dramatic re-pricing of central bank expectations seems exaggerated
All this makes you wonder what is actually more exceptional: the fast and furious reversal in risk appetite after the unexpected Brexit outcome, or the coinciding re-pricing of monetary policy expectations globally. A broadening consensus remains worried about rising political instability (creating potential headwinds for risky assets) and seems increasingly open to embrace negative yields for DM sovereign bonds as a new reality that is here to stay.
Although the latter is certainly true to some extent, the dramatic re-pricing of central bank rate setting behaviour (more easing by the ECB, BoE and BoJ, less tightening by the Fed) that has occurred over the last three weeks seems exaggerated. After all, we have not seen substantially more negative feedback loops through political and market channels or actual evidence of weakening growth momentum. At the margin, the opposite has actually happened: signs of a bit more support for the EU in European polls are visible, financial conditions have eased globally and, as said, economic data have improved. Therefore, our allocation stance remains very light on government bond exposure and tilted towards higher risk premium assets like equities and fixed income spread products.
Valentijn van Nieuwenhuijzen, head of Strategy at NN Investment Partners