The theory of efficient markets states that asset prices incorporate all available information and take into account all factors that will influence the prices. But in recent years, investors have been increasingly challenging this theory – no longer anticipating events and instead waiting to see the risks that emerge before setting the prices.
Central banks of developed countries are partly responsible for this phenomenon; in response to the financial crisis of 2008 they have responded with aggressive monetary policy, maintaining rates at historical lows, to the extent that nowadays 40% of sovereign bonds offer negative yields. In fact, they not only used traditional monetary mechanisms, but also bought financial assets that would have a direct impact on prices, offering some kind of ‘protection’ against falls in the price of financial assets.
Over the years, the impact of turbulent events – such as Grexit, China’s hard landing, Brexit or the emergence of nationalist sentiment across the world – on the prices of financial assets has diminished, not only in magnitude but also in the time taken for the assets to recover their previous prices after the shock.
In this context, investors started omitting the price of financial assets the probability of shock events, therefore making it difficult to evaluate the risk-adjusted return on investments; making it more important to analyse risks and the impact they have across the different asset classes.
Actually, there are two opposite forces that are guiding asset prices. On one hand, global growth is starting to accelerate, but on the other hand, political events are causing greater uncertainty – especially in developed countries, creating a significant potential risk to medium-term growth.
Over the years, stocks and high yield bonds have accumulated important returns, signalling that between these two forces growth is winning the battle, whereas the low cost of hedging downside risk reflects the lack of concern investors have on political risks.
In this context, our main challenge at PUENTE is to correctly weigh risks to determine the best investment opportunities. Currently, we believe that credit risk presents the best risk-adjusted returns, with Argentine bonds as our top pick. However, with the prevalence of so much political and financial uncertainty, diversification becomes important. We therefore believe it’s necessary to allocate a share of the portfolio in risk-free assets, offering significant capital gains at times of increased risk aversion, thus providing protection to the portfolio.