Diversification has decreased in the financial markets due to the growing central bank stimulus. Investors are hunting for yield in more risky and illiquid assets which tend to correlate with each other in distressed markets. Can slow-moving investments still bring diversification in ever-faster liquid markets?
Once again, the COVID-19 crisis demonstrated to us that there is very little diversification available in the financial markets. The values of all risky, carry-seeking asset classes collapsed at the same time as investors sought scarce safe-haven assets. Even many hedge funds did not actually hedge investors in the midst of the crisis, and there were very few strategies in which to hide in the alternative risk premia space too. After the global financial crisis, it shouldn’t have come as a surprise that there are no correlation benefits in a situation where dimensions of the financial markets disappear into the black hole of market singularity.
This time was also no different in the sense that in the eye of the storm, the cavalry of the central banks rushed to the scene to save innocent investors from the realization of market risk. Moreover, the central banks were using the same monetary policy tools that were used successfully during the previous crisis. The only difference was the speed and the volume of the quantitative easing decisions to stop the financial markets’ total collapse. Within a month from the beginning of the epidemic, the U.S. Federal Reserve’s Chairman Jerome Powell borrowed Mario Draghi’s famous “Whatever it takes” phrase and added “as long as necessary” to it. Everything happened as if in fast-paced movie, but that did help to support collapsing markets.
Markets are increasingly driven by central bank stimulus
However, it seems that something has changed in the financial markets in recent years. Since the global financial crisis, major central banks have doped the markets with liquidity injections in every major market downturn. Concurrently, growing monetary stimulus has pushed high quality interest rates to record lows, forcing investors to hunt for yield in more risky and illiquid assets. Decreasing liquidity in the investment portfolios cause markets to react mightily if investors begin to fear and withdraw their investments. In consequence of this, central banks are required to give more stimulus time after time to maintain stability in the markets and in the whole economy.
That all has led to market dynamics where the availability of market liquidity has replaced the fundamentals of the economy as a driver of investment returns. Investors are holding risky assets to achieve positive expected returns in an environment where expected returns of safe assets are at best around zero. Whenever there is a fear of weakening sentiment in the markets, investors are reducing their risk allocation by selling risky assets at the same time. When there are no natural buyers, all the risky assets drop at the same time and their correlation approaches one. Then central banks come in to boost liquidity to the markets, causing all the risky assets to recover at the same time. As a result of this, we have ended up in a one-dimensional market space, which fluctuates according to the changing perceptions of market liquidity.
Investing fast and slow
Daniel Kahneman explains in his famous book, Thinking, fast and slow, that there are two systems that drive how investors think. System 1 refers to fast, instinctive and emotional thinking. It relies on heuristics and associates new information with existing patterns, which we have already learned from historical experience. A system 1 thinker knows that markets will turn up with central bank stimulus, because it has already happened before. That heuristic has been enough for the risky assets to start recovering at the same time, and the biggest worry seems to be, whether we will get enough stimulus to keep markets rising. System 1 does not make any rational analysis of the changes in the market environment and it has not even been necessary in the liquidity-driven markets during the COVID-19 crisis.
Instead, system 2 refers to slower, more deliberative and more logical thinking. There is a traditional perception that investment decisions rely on carefully prepared financial analysis and system 2 type of rational reasoning based on the analysis. We are used to the idea that well informed, rational investors make better investment decisions, that lead to the better investment results. But is that idea itself based on stereotypical thinking and heuristics, meaning system 1 type of thinking? What if liquidity-driven markets are here to stay and there is no more value added in careful financial analysis and rational reasoning? Maybe the deep and long-lasting underperformance in value investing is trying to tell us just that.
Are there still somewhere system 2 type of slow investments where rational investment analysis matters? They should be investments which are not directly affected by market pricing and central bank actions. It requires investors to turn towards the most illiquid part of the investment universe, where irrational moves of the financial markets do not shake asset prices. It implies that these kinds of illiquid instruments, by definition, add diversification to the liquidity driven portfolio. Many investors are forced to hunt for yield and increase the risk level of their portfolio in the zero-rate environment. In a sudden liquidity-driven crisis, slow-moving illiquid investments might be the only diversifiers in their investment portfolio. An only practical problem for investors is to find such illiquid investments and price them rationally without marking to market.
The article has been published in the Q3 edition of EQDerivatives Magazine in September 2020.