The Brexit is Coming, the Brexit is Coming…
June 23rd, 2016 will be a day that lives in infamy, at least for the members of the European Union (EU). News of the Brexit, the United Kingdom’s vote to exit the EU, dominated headlines during the last weeks of the quarter. The major concern is contagion, what happens when the UK leaves and will it spur other members to leave?
Given that the UK is the second largest economy within the EU; this departure would be a major blow to the economic stability of the EU. Fortunately, for short-term investors, the markets bounced back for joy during the week of June 27 th as it became clear that the citizens of the UK are second-guessing their vote to leave the EU. Central banks around the world are standing by to battle contagion. There is still much uncertainty surrounding the Brexit which will contribute to higher volatility in the coming months and years ahead. This is why we remain ever focused on monitoring and maintaining the right asset allocation for your financial planning goals.
Market Forces and Asset Allocation
There is a lot of talk out there in the financial markets about asset allocation. In essence it means allocating capital to different assets, or areas in the world, to maintain certain risk exposures. The expectation is that risk exposure translates into returns over time. These different asset classes can be broken down into four distinctive risk factors: market, credit, interest rate and liquidity risks.
Market risk is the easiest to understand. If you are invested in stocks, you would expect the holdings to go up and down with the stock market (whether it’s US, international, or emerging markets). That’s market risk.
Credit risk is also known as default risk. Bonds with higher default risk compensate investors with a higher coupon or interest rate. Today, the higher paying bonds are called high yield bonds. In the past they were known by another name, junk bonds. To summarize, investors demand a higher rate of return as default risk increases.
Interest rate risk is the same as inflation risk. The rate of return on US government debt, a “risk-free” instrument, is roughly equal to the rate of inflation over time. In theory, a risk-free investment should not return a higher rate than inflation. The current 10-year Treasury bond yield is less than 1.4%, meaning that the market is expecting the inflation rate to be around 1.4% over the next 10 years.
The last risk, liquidity risk, is the hardest concept. This is defined as the compensation that you receive for “locking up” your capital. Think about a 3-month CD vs. a 12-month CD. You would expect the 12-month CD to pay a higher interest rate than a 3-month CD, that difference is the illiquidity premium. In times of stress, illiquid investments do not perform as well as other traditional assets. However, the lack of performance is due to investors rushing to liquidate these assets and not due to the erosion of the underlying investment itself.
Over the past couple of years, we have changed the way we invest money. Rather than using a traditional asset allocation strategy that would give you an exposure to market and credit risks, we have made changes to incorporate interest rate and illiquidity risks. The exposure to these two areas has proved to be a great diversifier for the portfolios this year. You will find some of these holdings under the Fixed Income and Alternatives categories on your Quarterly Report.
The market is ever-changing. Today, there are about $10 Trillion dollars of bonds with a negative yield. This is unprecedented and a direct result of central bank intervention around the world. We believe that Brexit, China, and the continued growth of shadow banking will keep central bank policies accommodative. We expect interest rates to stay low for the foreseeable future.
Shadow Banking
Shadow banking is defined as financial institutions engaging in banking activities but are not banks. Lending Club, which is based in San Francisco is a great example. Lending Club raises capital from investors to make loans. Investors here are taking credit risk with their capital which does not offer the same protection as bank depositors with FDIC insurance. These financial institutions have always been around but really grew out of the 2008/ 2009 recession, to fill a void left by the banks. The banks heavily modified their lending standards after the recession, so the traditional sources of lending were not available. Shadow banks emerged to fill the vacuum.
Keep in mind credit risk is very binary. The borrower is either paying or not, there is no in between. Due to the nature of the payments, credit risk is more hidden. The Financial Stability Board estimates that there are over $80 Trillion dollars in such unregulated banking (2016). The exponential growth of shadow banking out of China is particularly worrisome. In the past year, we have seen an uptick in defaults there. We shared some of these concerns in our Q1 2016 newsletter.
Keep Calm and Carry On
Asset allocation is not simply using different holdings to gain an investment exposure to certain sectors. Instead, it is an active allocation to certain types of risks. We believe that the best strategy going forward is to actively allocate capital to all four of these market forces. By doing so, we can more optimally control the risk and make sure that the asset allocation is appropriate for your financial plan and goals. We are keeping calm in this volatile environment and plan to carry on as with any other year, looking ahead and making changes as necessary.
Despite the swings and swoons of the global markets, here in the US, the equity markets made a last ditch effort to end the quarter on a high note. The Dow and the S&P 500 ended up 1.4% and 2.5%, respectively. Unfortunately, the foreign markets could not bounce back enough and ended the quarter down 1.5%.
Archvest on the Move
This August marks another year of business for us, and as we celebrate, we want to thank you for the continued support and trust. We have grown by leaps and bounds over the past couple of years and we could not have done it without your help, so thank you! As a result, we will be moving to a new location to further our ability to grow. Starting August 1st, our new address will be 2820 Shadelands Drive, Suite 130, Walnut Creek, CA 94598. Our telephone number will remain unchanged. Once we are settled in, we plan on hosting an open house to welcome you to our new location. In the meantime, if you are in the area feel free to pop by our office and say hello.
Here’s to another year ahead for us at Archvest and to you in reaching your personal financial goals!
Your Team at Archvest,
Eric Lai, John Wenzel, and Kimberly Terry
Eric Lai, John Wenzel, and Kimberly Terry | Archvest Wealth Advisors