I attended a presentation by a firm last week, considering asset allocation in a low yield environment. The firm in question is a US based quant shop (they style themselves as ‘systematic investors’), who employ some highly regarded market practitioners as well as banks of PhDs. They run a range of strategies including risk parity.
The presentation was elegantly crafted and engaging. Its central theme was that bonds still have a full role to play as diversifiers in balanced portfolios and that investors should continue to rely upon capital values to appreciate despite the paltry yields on offer. This argument is almost entirely reliant on the assumption that there is no lower bound to interest rates.
To be fair to the presenter, he did make worthy arguments why interest rates can fall into materially negative territory and I agree with him in theory that negative rates could provide monetary stimulus. The reality is that savers won’t accept them and the banking system doesn’t seem to be able to cope with it. So far, there is precious little evidence that negative rates have helped the European economies and plenty to suggest that it has had a deleterious effect on the European banking system. Draghi has signalled that we are approaching the limits of what monetary policy can do and Carney has highlighted that the building society sector in the UK cannot cope with negative rates. Sorry, I just don’t buy the idea that interest rates can fall much further in Europe and the UK.
Later I reflected on why the firm had chosen this topic to discuss and where their interests lie. Although they could be correct in suggesting that interest rates can go materially negative, it just seems implausible. What is certain is that the firm runs a significant amount in risk parity strategies, which are almost entirely dependent on government bonds continuing to act as offsets to equity risk. Unless interest rates do fall into deep negative territory in the next recession, government bonds will become much poorer diversifiers. As for the firm’s line of reasoning, the words of Mandy Rice-Davies kept echoing in my head - “Well, he would [say that] wouldn’t he”
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