Other ways to make money
“A person often meets his destiny on the road he took to avoid it.” Jean de La Fontaine
Thankfully, there were ways to make money in September away from traditional equities and bonds. Why thankfully? Well, UK equities fell -2.8% in the month and UK government bonds lost -0.6%. Investment grade and high yield bonds also lost money. Internationally, the picture was similar. For US dollar investors the S&P 500 index fell -1.6% and US government bonds lost -0.5%.
Our point is not that these are particularly sharp falls – especially in the context of the large run up in equities since the end of 2011 – but that September was another month when equity and bond prices moved in the same direction. This is the opposite of the more traditional picture of bonds offering protection if equity markets fall and vice versa. If you think bond markets will save you from sharp equity market losses you may be in for a different destiny. In other words, it is worth preparing for more months like September.
The reason is that central bank policy is at the heart of these market moves. Central bank QE programmes work by buying government debt from the market. This pushes investors who sell the government debt into other asset classes. Government bond sellers become investment grade debt buyers; this creates new investment grade debt sellers who buy high yield; high yield debt sellers then buy equities. QE therefore creates a world where bonds and equities move up in prices together. This is in fact one of the stated aims of QE: higher prices for equities and bonds creates a wealth effect which can help boost the recovery.
The problem, however, is obvious: the slow withdrawal of QE should see this positive price effect reverse. Falling bond prices would see falling equity prices as government support is slowly withdrawn. September may therefore be a harbinger of markets to come.
That’s the bad news. The good news is that the same forces that are pushing bond and equity prices moving together are creating opportunities in other markets to make money.
Note the scenario we have painted above assumes that the impact of QE is always the same everywhere. This is not in fact true today and will be less and less true in the future. The UK and US economies are slowly coming off life support and the direction of QE (and by implication, central bank balance sheets) is likely to be down. For Europe and Japan, the opposite is true. Japan is trying to jolt itself out of a terminal looking illness, Europe is desperately trying to fall ill with the same disease. Either way, balance sheets in these two regions will go up with the ECB looking more and more like the Bank of Japan.
One place these dislocations show up is in currency markets. Tighter money in the US and UK should mean stronger currencies, particularly against regions where QE remains in full force like Japan and Europe. Again we saw this in September. The US dollar gained almost 4% against the Japanese Yen and almost 3% against the Euro. Sterling also made similar but smaller gains.
This all helped our alternatives funds – many of whom are active in currency markets – have a strong September and make up for equity market losses. The job, of course, is to make money over longer periods than just a month but if we are right about QE and its effects on the markets we think we will be well positioned for the future years.