Central banks head to Quantitative Tightening: how to protect your assets
While there might be a difference in the amount of capital deployed by professional versus SMSF investors, the way risk is approached can be surprisingly similar.
While there might be a difference in the amount of capital deployed by professional versus SMSF investors, the way risk is approached can be surprisingly similar. The key is to understand there are inherent risks in markets, and look for ways to hedge them.
Where there is a disconnect between uncertainty and market pricing of that uncertainty, it is vital to seek protection from that gap.
For example, let’s say uncertainty is unusually high in markets. The first step is to look at market pricing of that uncertainty. If the market is taking a complacent approach then there is a risk of a correction. That’s the point at which you should look for ways to manage risk in your portfolio.
Current market conditions
When thinking about risk in light of current market conditions, it’s important to understand that markets have been protected over the last few years as central banks have employed a monetary policy known as quantitative easing (QE).
QE is a strategy through which the major global central banks, for instance the European Central Bank (ECB), US Federal Reserve, and the Bank of Japan (BOJ), have kept interest rates at record low levels. At the same time, central banks have been acquiring assets to support financial markets.
This has helped to maintain investor demand in the market and also reduce volatility. QE has been one of the most significant monetary policy programs put in place since the financial crisis of 2007 to 2009.
But now central banks are moving away from quantitative easing and into an era of quantitative tightening (QT).
As central banks have been buying assets they have increased the size of their balance sheets. However, now they are looking for opportunities to sell the assets they acquired during the era of quantitative easing and slowly reduce the size of their balance sheets. That's the quantitative tightening phase.
As central banks sell down their assets, this could prompt a period of heightened volatility in markets.
As per typical market dynamics, while some areas will suffer as dynamics change, sectors such as financial services that have suffered during quantitative easing are likely to improve their performance as we move into quantitative tightening.
As we move from QE to QT correlations between asset classes are likely to change. It is dangerous in this environment to rely on historical correlations between asset classes and assume your portfolio will remain diversified.
As markets correct during this phase, it will be important to watch correlations between asset classes closely.
When the portfolio is too correlated across asset classes the risk is the value of assets will decline in tandem. But if the assets are properly diversified taking into account current market conditions, there is a reduced risk the value of your portfolio will decline when the market undergoes a correction.
Navigating ups and downs
Markets often go from one extreme to the other. What tends to happen is that investors over time become complacent about risk and once this complacency ends, they overreact.
However, once there is an appreciation of the inherent risks, markets tend to go the other way and price in too much risk, going from one extreme to the other. When risk is fully priced in that’s the time to look for opportunities and when risks are not priced in its time to implement hedges in your portfolio.
For instance, if you have an allocation to equities, one hedge would be some exposure to gold when geopolitical tensions build up. Or if you think the value of the US dollar will decline you might protect your portfolio by buying Australian dollars.
At the end of the day, the idea is to identify ways to protect your portfolio that few other investors have identified.
Finally, when markets are volatile or falling it can be tempting to limit drawdowns. But that distracts attention from building wealth.
Instead, investors should maintain a watching brief over the risks in the market and ensure their assets are not too correlated, to properly protect their portfolio from market falls over time.