Noise and substance

2019 has so far proven another good year for the financial markets. Since the big financial crisis of 2008 markets have moved most of the time up. This is in spite of a macro environment with considerable tensions and headlines which generate renewed market concerns regularly. Chief among those concerns is the trade war between the US and China. A tweet of President Trump is enough to move markets up or down depending on whether it suggests a hardening of the positions or a possible return to the negotiation table.

In addition, other concerns have been ongoing for the last couple of years among investors including elevated valuations levels by historical standards and the fact that after ten years of expansion in the global economy the risk of a cyclical downturn is increasing every day. Of course the geopolitical hotspots of North Korea and Iran have been on the mind of investors as well as the slowdown of the Chinese economy, the Brexit that seems to drag-on forever with no resolution in sight and further issues as well.

News related to such issues have impacted markets only over short-term periods varying between a few hours, a few days or a few months. Overall the trend has been up. The cause of that uptrend is clearly recognized as the accommodating policies of the global central banks that have all used a range of tools aimed at supporting the markets and the real economy. While the impact on the real economy is a complex matter which is hard to evaluate the impact on financial markets is clear. Increasingly lower interest rates have resulted in increasingly higher asset valuations for all asset classes as investors were increasingly incentivized to move away from cash. 

Historically interest rates have always been a key driver of financial markets. The continuous fall in interest rates over the last three decades has been a major factor behind the strong performance of financial markets during this time notwithstanding the big financial crisis. International conflicts and major political tensions both within and between nations do not usually have a major, lasting impact on the financial markets. Interest rates represent the real story and the substance behind the tectonic shifts affecting financial markets.

How interest rates move and what affects them is probably beyond the current grasp of even the most insightful economist. From a practical point of view they are cyclical. With rates at historic lows, close to or even below zero, some of the most successful fixed income investors have thought over one year ago that a turning point had been reached and that rates could not go much lower. However, after a short rebound, US rates are back to historic lows. But by international standards they are comparatively high. While no one knows with certainty where they will go, the legendary former chief of the US Fed, Alan Greenspan now believes that it is only a matter of time before US rates go negative 1. Others also think so 2.

If interest rates continue to go down this will act as further fuel to asset prices. On the other side in the event that the trend turns again many of the recent gains will be reversed and there is potential for significant losses.

In the current environment investors are walking on eggs. With the uncertainty affecting further evolution in interest rates and market moves it makes sense, especially for the risk-averse investor, to allocate a significant part of his portfolio to investments that are less correlated to the financial markets and likely to generate positive returns independently of market conditions. This can be achieved by lowering the exposure to the traditional stocks and bonds portfolios and increasing the exposure to alternative assets such as first-rate hedge-funds, private equity and venture capital, alternative finance and direct investments. 

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1. Alan Greenspan says it’s ‘only a matter of time’ before negative rates spread to the US

2. "Why US bond yields could be going the way of Germany and Japan"