The credit crunch era has seen not a few previously accepted tenets and sacred cows bite the dust. Unfortunately this has not stopped some from continuing to believe in them. For example my profession of economics has for a long time used the concept of a risk-less asset. Now, whilst in theory one may be able to grasp and define such a concept once you move into the real world problems always began to appear and these have mounted in the credit crunch era.
For example some argued that an asset is risk free if you have certainty of return such as a bank bond. I hope their money was not in a bank which failed! More commonly it was assumed that US Treasury Bonds were a risk free asset as the US Treasury could always print more money to pay them. Economists used them in their models as a risk-free interest rate too. The concept of a potential default by the US government must have seemed inconceivable to them whereas now it is certainly conceivable. Actually it also ignored the fact that governments more often default on their bonds than their bills. Also domestic investors had the problem of inflation which erodes the real value of their asset and overseas investors could add the exchange rate to the list as a clear risk. So we see that the theory was even in better days forced on reality and in these difficult times does not fit it at all.
As we conclude above that there are no risk-less assets we find ourselves also concluding that true or pure safety has to be an illusion. There is no “safe asset” as the theory becomes a mirage once reality hits it.
This does not mean that there are no assets with elements of safety in them merely that they vary across a spectrum from less to more safe with no polar extreme to be found. As we consider the concept we also realise that safety means different things to different investors because it at least partly depends on their concept of safety.
What is a safe haven?
Investopedia defines it thus.
An investment that is expected to retain its value or even increase its value in times of market turbulence
Actually I am not a fan of that as to me the concept of a safe haven covers countries as much as it does particular investments. Fortunately they do then throw in another sentence.
Safe havens are sought after by investors to limit their exposure to losses in the event of market downturns.
Much better. What this now tells us whether intentionally or not that like beauty a safe haven is in the eye of the beholder. It depends on their circumstances wishes and needs. Let me give you an example of this.
It was only a few months ago that the Swiss Franc was considered to be such a safe haven by investors that they received negative interest rates on investments denominated in it. Some invested 100 to get back 99.6 in two years and this did at its peak extend out to the five-year maturity. But they did so and if we look wider we may be able to figure out why they did.
In Switzerland under the current regime there is no inflation. The Consumer Price Index which was based at 100 in 2012 was at 99.3 on average in 2012 and had fallen to 98.9 in December 2012. So here is one reason why a nominal loss may have been accepted. Investors may well still have thought that there could be gains in real or inflation adjusted terms.
As ever we have another problem as the policies of the Swiss National Bank in capping the Swiss Franc against the Euro created a future inflation risk but let us park that one for now.
Here presumably foreign investors were hoping for a further appreciation of the Swiss Franc. They no doubt hoped that the negative rate of interest would be swamped by the capital currency gain.
What I mean by this is a country which has an economy which looks as if it is sustainable for the long-term and Switzerland would get quite a few ticks on such a list. As we peruse her balance of payments surplus and her national debt to economic output ratio of 35% we see an economy that looks stable. We have been taught by the credit crunch that apparent stability can go wrong quite quickly so even such apparent stability is only for a fairly finite period of time, but the new reality is that it is about as good as it gets.
Here our idealised safe haven would have simply stability and certainty with anything like a revolution being extremely unlikely. Perhaps in the modern era we should add that it also has a political class which does not keep looking to foreign fields for wars either.
Price and value
This is something I so rarely hear being discussed or see being written about. I believe that you cannot measure safety or risk without also referring to the price of something which helps to give an idea of value. I have argued for something that the UK Financial Services Authority has imposed completely the wrong set of risk categories on investment advice in the UK for this reason.
Let me explain in the context of the UK government bond or Gilt market. The FSA have this as a low risk asset. Whereas in my opinion the rise in prices and fall in yields that we have seen in recent times have made them a riskier asset. For example as our benchmark ten-year Gilt yield dropped from over 5% in the summer of 2008 to 1.46% in the summer of 2012 then the risk went up. Indeed those who bought at the low yield or price high will be mulling this fact right now as prices are falling again and our benchmark yield has hit 2.16%.
In a country regarded as a safe haven we need to consider the exchange rate on the sam basis.
The Currency Twins
If you look back over past updates on this blog you will see articles where I discussed the Swiss Franc and the Japanese Yen who via the backwash of the carry trade became the “currency twins”. Their surge saw them labelled as currency safe havens but it we return to our higher price leads to higher risk thesis we see that the outcome has meant that the status of the Yen in particular as a safe haven has been topedoed below the waterline.
The Yen passed 80 versus the US Dollar in mid-November and as it is at 93 as I type this then it has proved to be a -16% safe haven over this period! Even the weak pound has not stopped the same being true for UK investors and of course the recent all conquering Euro means that a safe haven play out of it into the Yen will have investors wallets calling for the stretcher-bearers.
Also we note that the previous relative stability between the Swiss Franc and the Japanese Yen has now moved into the past.
In a world where there is plenty of flexible and mobile capital we also have to face the issue of size or amount. What I mean by this is that at times the amount of capital looking for a (supposed) safe-haven can swamp the market it is going into. When we consider that such a large market as the Japanese Yen was swamped by such flows we wonder what markets could with stand and sustain a genuine “safe-haven” rush? Not many if any….
You may have noted that I have managed to get a long way into this post without mentioning the classic safe haven investment which is gold. This is because it is in my opinion a clear minefield. Some factors are there as for example its use for jewellery but against that you get no return. In fact in many ways its appeal relies on its durability which is another way of saying you get no return and uses are few. After all did not King Midas discover the problems created by being able to turn everything into gold?
So we end up with much of its appeal being based on psychology. If sufficient people believe in it then it will remain a safe haven although we return to the issue of at what price?
Zero sum games
More and more markets such as derivatives are in fact zero sum games. In fact if we allow for costs we see that they in fact in total give a net loss. This seems to take them out as being safe havens although as discussed above at a low price they may work.
So having considered the position we see that safe havens are in fact as Imagination put it some years ago.
It’s just an illusion,illusion,illusion
However we also know that there are times when human nature is such that safety is prized and we also know that in these times that a flood of capital will go that way. So anticipating such a move is perhaps where we will find the nearest to a safe haven trade. In which case we are likely to find our safe haven in an unexpected place as we reject what is strong now like the Euro and look for what is going to be strong going forwards. If Tom Petty was right about this.
Baby, even the losers, get lucky sometimes.
Should we be looking at something like the UK pound and anticipating a change of fortune? As I type that I have remembered something which I have not addressed fully so far and that is of the time-horizon which matters too.
As ever I await readers thoughts on this.