Simultaneous tightening by central banks will determine main risks and opportunities of 2018
Countries considered high risk may offer better returns than traditional safe bets
The main risks and opportunities for investors will derive from the same place in 2018 – central banks tightening simultaneously as a result of domestic reasons. Tightening individually would probably be OK, but all of them acting in synchronicity may have an affect the markets are not prepared for.
However, this is also a huge opportunity. First, because it will create more volatility in systematic risk factors, which in turn creates more areas in which to invest; and second, because some central banks will continue to ease, creating differentiation. It may well be that some countries that in the past have been considered high risk may end up as better places to invest in than the traditional “safe” countries, because of this diversion in monetary policies.
It is important to differentiate between systematic and idiosyncratic risk. Systematic risks describe major factors such as credit spreads, movements in equity markets, rates and so on. Idiosyncratic risk factors are those that move in a different direction than the broader market. They dance to their own tune. I think most people would agree a majority of systematic risk factors in the world at the moment do not offer a good risk/return opportunity because rates are so low, credit is tight and volatility is muted.
One way of responding to this is to allocate more to idiosyncratic risk assets that are sufficiently driven by their own stories to behave differently than the broader market – that have some “hair” on them, as we say. However, there tend to be few of these idiosyncratic risks about, which means that to benefit from them it is necessary to take more concentrated positions over a longer time horizon and be willing to tolerate some adverse outcomes.
Looking at the insurance sector in particular, you can take it in two main ways – you can either be underweight or short something that tends to be high yielding, which presents an opportunity cost, or you make a direct outlay on options. Both types of insurance are currently cheaper than they have ever been. In the first case, this is because yields are so low that there is little opportunity cost in not owning them, and in the second case it is because implied volatility is low, which reduces the cost of options.
Despite being so cheap, however, it is questionable whether insurance has offered good value for money over the past few years. In recent times, the markets have not been moving sufficiently when bad things happen for people to benefit from holding insurance. When North Korea fired a missile over Japan, for example, the market reaction was one of nonchalance; when the UK voted to leave the EU, the reaction was more severe but lasted only around five days. Were these reactions the “correct” ones? In my view, no, but we have to deal with how markets actually react, not how we think they should react.
So the question for next year is whether the market will continue to be nonchalant, or whether there are exogenous risk events on the horizon that mean that it will not have a choice but to react. We think there are risks that will still require some form of insurance, primarily central bank tightening and the situation in North Korea.
The bottom line is we are all looking for income, protection against the downside and diversification. I don’t think that will ever change. However, it is also clear that the usual sources of income and protection are not working as well as they have done in the past – yields are so low that US treasuries no longer offer the same protection, while traditional income products are generating less income.
This means that we have to look in different places for these qualities.
Did the last financial crisis leave us better prepared for the next one? Yes and no. No, because the next crisis will be fundamentally different. The world worked very hard to fix the credit problems that caused the previous crisis, but one of the consequences is that attention may have been diverted from the potential causes of the next crisis. So we may be underprepared in that way.
However, we can also say yes because the experience of the last crisis has left the world better equipped psychologically to deal with the next one, despite authorities not having the necessary tools immediately at hand.
Arif Husain is global head of fixed income at T. Rowe Price