From grey swans to investment opportunities

Juanita Escobar, IOOF Portfolio Manager - Fixed Interest and Cash

A ‘grey swan’ event has evolved, in today’s environment of economic uncertainty, from the concept of the black swan theory developed by Nassim Nicholas Taleb – that is, an event that deviates so far from what is expected, it is nearly impossible to predict. Unlike a black swan event however, grey swan events may be more frequent and can be anticipated to a certain degree, while still having a sizable impact on the valuation of a security or the health of the overall market if they do occur.

In the current market where grey swan events are increasingly likely, increasing cash holdings contributes to the risk management process and its execution. In many cases, cash can be considered as a flexible factor in the investment opportunity discovery and portfolio construction process supporting diversification and long term portfolio positioning.

Investors around the world are being affected by low and in some cases negatives cash rates and bond yields, exacerbated by increasing global savings from an ageing population which are only likely to rise. Despite this, bonds and cash are – and will remain – part of the defensive havens as they offer downside risk protection and capital preservation. These assets provide liquidity and protection against deeper drawdowns of riskier assets. While there is interest rate risk for longer-dated securities, particularly for stronger economies where interest rate hikes are more likely, bonds remain a valuable anchor in multi-asset portfolios due to their lower volatility versus risky assets.

Some Australian investors may consider current bond yields and cash rates too expensive when compared to historical levels. Nonetheless, these markets could be considered a very attractive opportunity when compared to negative rates in other global economies.

Today’s markets face growing volatility driven by economic and geopolitical uncertainties. With global data factored into the world’s major central banks policy-making and economic growth forecasting, increasing cash holdings at current interest rates may be not too expensive as a capital preservation principle (or perspective). Cash investments can also be considered a great risk management tool as they provide flexibility when superior risk reward investments opportunities arise.

Cash contributes to the portfolio construction and asset diversification and neutralises the negative performance of others assets - even more so, when more grey swans are expected. And while past performance is no indicator of future performance, the returns on cash and fixed interest over the last year might surprise you.

Fixed interest markets performed well as investors shied away from volatile equity markets with Australian bonds returning 7.0 per cent and international bonds returning 9.34 per cent. Cash returned 2.2 per cent over the financial year reflecting the 25 basis point rate cut by the Reserve Bank of Australia in May to a historical low of 1.75 per cent. The Australian share market finished the year up 0.9 per cent, which goes to show, the safest option doesn’t necessarily mean the least rewarding.

The information contained in this newsletter is provided on behalf of the IOOF group of companies and is intended for financial adviser use only. It is given in good faith and has been prepared based on information that is believed to be accurate and reliable at the time of publication. Any examples are for illustration purposes only and are based on the continuance of present laws and our interpretation of them at the time.