Canadian Investment Review

How central banks have broken financial markets

Written by Caroline Cakebread on Monday, December 3rd, 2018 at 12:55 pm

Liquidity word built with letter cubes © macgyverhh / 123RF Stock Photo “Knowledge is knowing that tomatoes are fruit wisdom is knowing that you shouldn’t put them in the fruit salad.” It’s a quote that is particularly apt in today’s, markets, according to Trevor Leydon, head of portfolio construction & risk, Aviva Investors.

Indeed, in a market environment that has been shaped by central bank intervention post-2008, investors need to dig deeper into how markets move and rethink their assumptions about how certain assets perform.

Investors who fail to do so will find themselves unable to respond adequately when the next market correction hits.

Leydon points out investors don’t typically understand the effect quantitative easing has had on volatility. “No matter what you’ve chosen over the last 10 years, everything has done reasonably well,” he explains. Every time there has been a crisis, central banks have stepped in to help ease the pain of volatility with stimulus.

Broken Markets

This has created a new kind of market environment, one where traditionally liquid assets  like stocks are becoming much harder to get in and out of.

Consider, says Leydon, the market correction that occurred in February 2018; trading patterns shifted markedly.

The size of futures trades in global equities collapsed in January, right before the correction.

“That tells you no one is market-making,” Leydon explains. “The S&P is going on a tear, but the market is telling you, you can’t trade it.”

Hence, investors who’ve always assumed equities are really liquid now have to start thinking about whether or not they can exit from them quickly when they need to.

This raises important new questions for plan sponsors to consider in particular, says Leydon, “Have central banks actually broken financial markets?” And, if so, what will you do when the market corrects next? Clearly, a generation of investors accustomed to central bank responses to market volatility will now behave much differently.

“These are things you need to consider in day-to-day portfolio construction,” concludes Leydon. “If you can’t act fast, what does that mean for your asset mix?”

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