No one remembers the 1970s
To have worked through the ‘70s you would have to be, say, 20 when the decade began. That would make you 65 today. Finance is notorious for the attrition rate on its employees and this means that there is, to a first approximation, very few working today who really remembers the 70s (myself included – I got going in the 90s).
On the other hand, nearly everyone in mid or senior-level roles in finance today remember the 2008 crisis well. The brutal falls in equity and credit markets ended some careers and a fear of a reprise remains etched into the consciousness of those who survived. Sharp falls in equity markets or a pick up in equity market volatility leads to plenty of headlines that suggest worse is to come. There are also plenty of investors and commentators who remain convinced another collapse is just around the corner. Perhaps because the last real bond bear market was in the 70s, big moves in bond markets tend to attract less attention. And proper bond bears are much harder to find.
The reality is, though, that bond markets have lately become riskier. The rolling 12 month volatility of UK bond markets is now in fact above that of equity markets (see the chart). This year alone the UK government bond index gained +4.9%, then lost -6.3%, then gained +4.8% and lost -3.9% again. This is more 1970s style behaviour than the bond bull market we have enjoyed for the last 25 years.
What do we take from this? First, we think that rising volatility in bond markets is triggered by two factors. First, harsher bank capital rules mean there are fewer market makers around to provide liquidity. Less liquidity to oil buyer and seller interactions means sharper and faster market moves. Second, this lack of liquidity is accentuated by central bank buying under the various completed and ongoing QE purchase programs. These have reduced the stock of high quality government bonds available to trade. Reduced supply of bonds (via QE) is meeting reduced market liquidity (via the bank regulatory capital changes). It is not a surprise that bond markets are not the haven of liquidity and safety that they once were. Our view is that both these factors will be around for a good while yet. So bond volatility is here to stay.
Secondly, on our, albeit simplistic, measure (rolling 12 month monthly volatility) bonds are now riskier than equities. Many traditional client portfolios are put together assuming safe bonds will offset riskier equities. How does this work when both markets are just as risky? What happens if (as in the 70s) rising interest rates trigger losses in property and equity markets? Lower risk clients in particular would be in for a nasty surprise. More generally, we are not sure that the traditional portfolio construction assumptions work in this sort of environment.
Rising interest rates triggering losses elsewhere would be difficult markets for everyone, including us. We can, however, limit our exposure to this by limiting the interest rate sensitivity of our portfolios. We can also seek out investments that do not rely on low interest rates today to look attractive. This we continue to do. Though we are (happily) too young to remember the lessons of the 1970s we think we have studied enough history to keep us safe should it come around again.