By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company
In a world of financial, economic and market volatility, not to mention uncertainty, investors of all kinds are on an unrelenting hunt for safe haven investments. It’s a topsy-turvy environment, one in which investments previously viewed as completely safe – developed country sovereign debt and triple-A rated mortgage-backed securities, for example – have been knocked off their pedestals, leaving investors wondering where to turn.
Safe haven investments are important to investors for a variety of reasons. They serve as anchors for both institutional and individual investors’ portfolios, balancing out more volatile investments. They are required investments for certain types of financial institutions and asset managers who must maintain low-risk or no-risk cash cushions at the behest of regulators, investment policies or both.
For many years, gold was the ultimate safe haven investment due to the belief that it had intrinsic value that other assets, such as currencies and equities, did not. During financial crises or panics, the value of gold has skyrocketed. The U.S. dollar, as the global reserve currency, has also enjoyed safe haven status. U.S. government debt has also benefitted from safe haven status, a position that has allowed the government to borrow at low interest rates. Those rates are rock bottom today due to that belief.
Whether the U.S. can continue its standing as a safe haven investment is open to debate. Looming issues such as the presidential election in November, the fiscal cliff coming in January and the potential for future credit downgrades could rain on this parade. In fact, the International Monetary Fund (IMF) published an economic report that discussed the role of safe assets in investing and concluded that as a result of sovereign debt issues, the world’s supply of safe assets is shrinking just as investors are seeking more safety.
In this month’s commentary, we’ll discuss why investors seek safe haven investments, identify traditional safe havens, highlight options that exist today for investors seeking security and examine the position of U.S.-based assets as safe haven assets. We’ll also explore the implications for investors and discuss what to look for when selecting safe haven investments.
While many types of institutional and individual investors continue to search for safe haven investments, the truth is that no asset is completely risk free. Because every asset carries some type of risk, it’s important that those risks are appropriately priced into assets. The IMF’s report notes that when risk isn’t appropriately priced into a safe haven investment, the value of those assets can plunge quickly.
One such plunge happened during the Global Financial Crisis of 2007-2008 when many AAA-rated mortgage backed securities were discovered to be much less safe than previously thought. More recently, sovereign debt troubles in Europe have resulted in plummeting values for bonds of countries on the periphery of Europe, such as Greece and Italy, as investors realized the enormity of the fiscal problems in those countries.
Safe havens serve a variety of purposes for investors, regulators and financial institutions in the global economy. In a report earlier this year, the IMF identified four functions of safe haven assets:
- Reliable store of value
- Collateral in repurchase and derivatives markets
- Instruments in fulfilling regulatory prudential requirements
- Pricing benchmarks
For investors, safe haven investments serve as a reliable store of value – that is, investors can rely on the fact that such investments will generally retain their value over a long period of time. Investors expect that investments they regard as safe will hold up during financial turmoil or crisis, cushioning a portfolio that may be subject to losses on riskier assets.
Financial institutions use safe haven assets as collateral in repurchase agreements and in derivatives transactions. These assets serve as a kind of insurance that the terms of an agreement will be fulfilled; if it isn’t, the collateral will be taken. Safe haven assets also play a role in financial regulation, as regulators typically require banks and other financial institutions to keep a certain percentage of reserves in the form of specific type of safe haven assets such as U.S. government bonds. Those reserves serve as a cushion if bank investments or loans go bad. Finally, financial institutions use Treasury bonds, bills and notes and other financial instruments such as the London Interbank Offer Rate (LIBOR) as a benchmark to fix prices and loan rates.
When assessing whether an investment is a potential safe haven or not, investors use several criteria. According to the IMF, these include low credit or market risk, ample liquidity and limited inflation risk.
Since the gold standard was abandoned in the early 1970s, gold has been considered by many as the ultimate safe haven. Because gold is a hard asset that has an intrinsic value, unlike other assets such as currencies or stocks, investors traditionally flocked to it during times of economic, political and market turmoil. Gold’s intrinsic value is attractive to investors who have faith that it will retain a certain amount of monetary value, even during catastrophic economic events such as a global economic depression or prolonged global financial crisis.
In September 2008, for example, gold prices surged in the wake of the Lehman Brothers collapse (fig. 1). When central banks enact monetary easing policies, gold tends to rise in value. That’s because monetary easing policies can depress the value of currencies, at least temporarily, as interest rates fall.
Real estate is another traditional safe haven, again because of its intrinsic value. Like gold, a house, apartment building, office building or manufacturing facility is an asset you can see and touch that likely will retain some kind of value regardless of the state of the economy.
Gold is much more liquid than real estate, which can be difficult to convert into cash quickly. Both gold and real estate are subject to bubbles, and investors who get caught up in this type of bubble mentality often have a hard time exiting at the right time.
The U.S. dollar, as the world’s reserve currency, is also frequently viewed as a safe haven (fig. 2). Because the U.S. has the world’s largest and most transparent financial markets, investors are attracted to the dollar despite the high level of debt coupled with ongoing political and economic uncertainty. And while experts have predicted the “death of the dollar” for years, there is no viable replacement for the dollar on the horizon. Currencies are certainly easier to trade than they ever have been in the past. They are liquid but can be volatile.
Sovereign debt, especially the sovereign debt of financially secure developed countries, has also been seen as a safe haven. The global financial crisis of 2007-2009 and the European Sovereign Debt Crisis that followed saw the debt of many countries that were previously regarded as safe havens cut by credit rating agencies. In addition, credit rating agencies themselves have come under scrutiny for a perceived lack of due diligence and potential conflicts of interest in their ratings processes.
During the 2007-2008 financial crisis, many U.S. assets – including the U.S. dollar, Treasury bonds, bills and notes, along with gold – became the safe haven assets of choice for a large swathe of institutional and individual investors. Even once the financial crisis passed, as the global economy has slowly, but not completely, regained its footing, U.S. assets continued to fare well. Couple that trend with additional U.S. Federal Reserve Board monetary easing policies and it’s no surprise that Treasury yields continue to remain historically low. In fact, the 10-year U.S. Treasury note yield has fallen from 3.36 percent to 1.56 percent in mid-August (fig. 3).
Although the risks in the U.S. economy are clear, investors perceive those risks as lower and more manageable than those in other areas of the world. The eurozone, despite years of negotiations and bailouts, has yet to completely or even partially resolve its sovereign debt crisis. Emerging markets are slowing down economically and are also perceived as more risky.
Other governments with triple-A credit ratings, including Germany, France, Australia, Switzerland, Sweden and the United Kingdom, are also enjoying some safe haven status. Sweden, for example, has seen foreign holdings of government bonds increase to 50 percent from 35 percent in the past year and a half. In Germany, yields on short-term government bonds are negative as investors are willing to pay to keep their money safe.
Many see highly rated U.S. corporate bonds as safe haven assets. As a result, many large U.S. corporations have been able to sell bonds at extremely low rates, locking in low payments to investors and securing extra cash on a long-term basis at very attractive rates.
Gold continues to be seen as somewhat of a safe haven by many, not only due to the fact that it has an intrinsic value, but also because of its low correlation with other investment assets. It is quite volatile, though, even though it is highly liquid. Government bonds from safe haven countries are subject to risk but generally aren’t as volatile in the short term as other assets.
In terms of currencies, the U.S. dollar, Japanese yen, United Kingdom pound, Swiss franc and – to a lesser extent – the Australian dollar, Norwegian krone, Canadian dollar and Swedish krona are viewed by many as safe havens. Of these, the U.S. dollar, Japanese Yen and Swiss Franc have a history as safe haven assets.
The IMF estimates that downgrades of formerly highly rated sovereigns could remove up to $9 trillion of safe assets from the global markets by 2016 at the same time that the private sector is experiencing trouble creating additional safe assets due to new regulations. Additionally, large-scale balance sheet expansion by central banks throughout the world has reduced the outstanding supply of safe assets.
Investors looking for safe havens may need to move their money around more frequently than they did in the past as they respond to global economic events. This could mean that investment managers need to be more vigilant in analyzing economic and investing trends and be more responsive to those events. If the quantity of safe haven investments is falling, as the IMF believes, it is likely that those safe havens will be priced higher in response to a shrinking base at a time of high demand. That is one explanation for the continued low interest rates on AAA-rated sovereign debt, where rates are at historic lows.
The IMF notes that in 2007, 68 percent of developed countries had sovereign debt that carried an AAA rating – in 2012, that percentage fell to 52 percent. As a consequence of the smaller supply of safe haven assets and other byproducts of this trend – such as extremely low interest rates – investors may be driven into other, riskier assets including corporate bonds, stocks, high-yield bonds, real estate investment trusts (REITs) and more.
Also, as investors compete for a shrinking supply of safe assets, the markets may become more subject to volatility and more bubbles may emerge in assets perceived as safe. Some economists argue that this is already occurring in Treasury bonds. If there is a bubble in Treasury bonds or other “safe” assets, many investors could get burned when the bubble or bubbles pop, yields on treasuries rise and the value of those assets declines. For example, many areas of the U.S. are just now recovering from the housing crisis. In many areas, values are one-third of what they were at the height of the bubble and could take a decade or more to recover their bubble-year highs.
For the countries that are seen by investors as having the safest assets, the shrinking overall supply of safe haven assets is a good news-bad news story. It is good news because those countries have breathing room to get their fiscal houses in order and are seeing their costs to borrow fall just at a time when they have to borrow more. It’s bad news because it removes the sense of urgency from policymakers who have less incentive to deal with bloated deficits (fig. 4).
In the U.S., the looming fiscal cliff could shake the confidence of investors if lawmakers don’t deal with it in a timely and responsible fashion. On one hand, investors want to see the U.S. come to some type of terms in dealing with its rising budget deficit, so budget cutting and austerity is welcome if it’s done with a long-term view toward creating a more sustainable fiscal climate. On the other hand, a repeal of some of the budget cutting measures that are set to go into place at the beginning of next year could help the economy in the short term. So negotiations over the fiscal cliff and the fast approaching expiration of the Bush cuts could be telling.
As far as other safe haven assets go, the ongoing sovereign debt crisis in Europe will continue to test the fiscal soundness of France and Germany. Germany has an AAA rating from all major credit rating agencies, while France has an AAA rating from Moody’s and an AA from S&P. Since credit rating agencies are always examining their ratings, these ratings could be subject to potential downgrade at any time.
In uncertain times such as our current investment environment, having a reliable safe haven is paramount for investors. Gold, sovereign debt and high quality corporate bonds have been the choice of many to fulfill this need over the years and continue to be so today. However, hard assets such as raw land and commodities are beginning to emerge as additional safe haven outlets, mostly due to the fear of decreasing purchasing power of the U.S. dollar.
A word of caution to investors: being late in a flight to safety can have negative consequences when financial markets return to normalcy. Put another way, pressing the panic button and strongly deviating from an investment policy usually leads to buying safer assets when they are relatively expensive and selling riskier assets when they are relatively cheap. When confidence is restored, the safer assets fall in price and the riskier assets rise in price. As a result, the investors who cry uncle and undertake this strategy can wind up with losses on the entry and exit from this ill-advised move. A better strategy is to adhere to a long-term investment policy that highlights disciplined rebalancing tailored to predefined risk tolerances.
Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.
Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.
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The International Monetary Fund (IMF) is the intergovernmental organization that oversees the global financial system by following the macroeconomic policies of its member countries, in particular those with an impact on exchange rate and the balance of payments.
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