How to invest in the current climate
What can advisers do to help clients understand the current relationship between equities and bonds?
With different macroeconomic events occurring across the globe, clients may be wondering how this will impact their asset allocation in their various portfolios.
A sudden drop in the price level of certain assets, can be a win for some investors and a major loss for others.
Bonds and equities have started to move in the same direction over the last few years.
This is in part due to historically low interest rates across the globe, and through quantitative easing, a policy pursued by central banks to purchase assets and drive the prices up.
The fact equity prices have risen at a similar pace and direction to that of bonds means that advisers may need to devise different strategies on how to diversify their clients’ portfolios.
Fund managers say because the main aim of central banks over the past decade has been to reflate asset prices in order to foster economic growth, it is ambitious to expect cheap assets.
Multi-asset is best strategy for defensive exposure
More than half of advisers said investing in multi-asset is the best solution for investors seeking defensive exposure, according to the latest FTAdviser Talking Point poll.
The poll asked advisers the question: “Given the valuation of both bonds and equities look high by historical standards, what are the options for investors who want defensive exposure?”
More than one in two (55 per cent) of advisers said multi-asset is the most popular solution to achieving defensive exposure.
Some 23 per cent advisers said holding cash is the next best option, while almost one fifth (18 per cent) advisers would recommend their clients to invest in infrastructure for defensive exposure.
Matt Riley, head of dynamic research solutions Natixis Investment Managers, said: “Because of the broad investment mandate multi-asset managers often have more flexibility to reduce or increase portfolio risk based on their assessment of market developments."
He added if multi-asset managers adjust correctly, a multi-asset manager can gradually shift into a defensive position in the lead-up to a bear market and can give more opportunities for diversification and hence risk reduction.
Hannah Owen, financial planner at Quilter Private Client Advisers, says: "An investor can also choose a low risk multi-asset fund for a defensive view which likely hold a lower proportion of equities than a similar higher risk multi-asset fund."
Most experts were unsurprised that absolute returns strategy was least favourable.
Mr Riley said: “The absolute return sector as a whole saw large outflows over the past months. The promise of absolute return funds is to have a positive return in all market conditions and recently a number of managers in this sector didn’t fulfil that promise."
Data from the Investment Association, the trade body that represents UK asset managers, showed that in March 2018, the absolute return sector was the worst selling IA sector in the month as investors withdrew £665m from the asset class.
Ms Owen added: “Cash is important to hold within a portfolio but cash doesn’t keep pace with inflation. Whilst cash and fixed interest provide safety in the portfolio, if growth is wanted in the portfolio, then other assets are needed.”
How bonds and equities are defying their conventional relationship
Words: David Thorpe
How the traditional approach to investing may be fading
The traditional approach to asset allocation is created on the assumption that government bonds move in the opposite direction to equities.
But in recent months, markets have not behaved in a conventional way, and both bonds and equities seem to be moving in the same direction.
This is largely due to actions by central banks, and a relatively benign economic environment.
It has created conditions that have left investors wondering where they should invest, especially if both bonds and equities fall dramatically at the same time.
Typical correlation between bonds and equity
Bonds and equities typically move in different directions partly because of what happens with inflation.
This is because when economic growth is strong, inflation is usually rising.
Rising inflation is bad for bonds because the spending power of the income from the bond is reduced.
This means investors sell bonds at a time of higher inflation, and choose instead to buy equities where the income can rise in line with inflation or higher.
Higher inflation also leads to higher interest rates as central banks put rates up to drive to prevent inflation getting to dangerous levels.
Higher interest rates usually makes the price of bonds fall because new bonds coming onto the market will reflect the higher interest rates, making the existing bonds in circulation less attractive to investors, and pushing the prices down.
Why this relationship reversed
But when an economy is closer to recession, then investors have traditionally sold equities to buy bonds.
This is because if an economic decline is imminent, then investors are willing to pay more for the security of the repayment from a bond, and less for the uncertainty of the returns that come from most equities.
If an economy is in decline, then central banks will typically cut interest rates in order to stimulate economic growth. That means future bonds coming into the market will have a lower interest rate, making those bonds already in circulation fall in price, so the price of those assets is likely to rise even as lower interest rates signal an economic downturn.
Because of the symmetrical relationship described above, bonds have traditionally been cheap when equities are dear, and vice versa, so the challenge for the asset allocator was to understand the outlook for the economy, and then buy the relevant portion of bonds of equities for clients.
But the challenge has changed over the past decade, with central banks maintaining very low interest rates, even as economic growth rates recovered, but also, through the bond buying programmes known as quantitative easing, keeping bond prices high.
A combination of low bond yields and economic recovery meant that equity markets have risen at the same time as bond markets, meaning the asset allocation challenges faced by advisers look very different to those of previous years, with bonds and equities expensive at the same time.
The severe market turmoil in the final three months of 2018 was a warning to investors that the steady returns of recent years may be reaching an end.
If the sell-off was severe, the reasons behind it were very traditional.
US interest rates had risen nine times, causing, as expected, the price of government bonds to fall sharply.
Impact of quantitative easing
But the reason central banks want to put interest rates up is to prevent inflation getting out of control and destabilising the economy.
The market reacted negatively because inflation in the US remained below the 2 per cent target level, and investors worried that the higher rates, in the absence of inflation, would tip the economy into recession.
This meant bonds and equities, having been expensive at the same time, fell in value at the same time, and so neither asset acted as protection for investors.
Guy Miller, head of macroeconomics at Zurich said the sell-off in December was probably “overdone” as economic data remained positive.
The resurgence in equity and bond markets seen so far in 2019 means investors are back where they started, with both asset classes looking expensive at the same time, and worries that have dogged investors for the past year, such as trade wars, political uncertainty and China’s growth slowdown, yet to be resolved.
John Husselbee, head of multi-asset investing at Liontrust said: “The basic investment instinct when looking to increase the defensive properties of a portfolio is to increase cash.
“But doing this in fear of short-term market moves can damage the long-term nature of a balanced and diversified portfolio. We are not in the camp of investors who believe it is possible to time the market.”
Mike Bell, market strategist at JP Morgan Asset Management UK said that while economic conditions may be unusual, the answers for investors seeking defensive exposure are largely the same as ever.
He said that however high bond prices are now, in a time of severe market stress, prices would continue to rise.
Mr Bell said that during the uncertainty in markets in the final month of 2018, government bond prices rose, as would be traditionally be expected to happen in those market conditions.
Sunil Krishnan, head of multi-asset funds at Aviva Investors said: “Because the main aim of central banks over the past decade has been to reflate asset prices in order to engineer economic growth, it is not realistic to expect there to be a stock of cheap assets out there.
"A great deal of capital has been burned in that time by investors comparing the bond prices of now with those of history and thinking therefore that prices couldn’t rise any more, but they did.
"Even last year it might have seemed a cast iron certainty that bond prices would rise, people thought bonds were done and we were coming to the end of the bull market, but they were wrong.”
Mr Husselbee said: “Despite a multi-decade bull market, bonds still offer investors a yield over the medium to long term, diversification benefits, capital preservation and, in some cases, inflation protection.
"We also seek further diversification using less traditional asset classes such as property, absolute return funds, hedge funds and commodities.
"While we are not prepared to time the markets, we do see merit in tilting portfolios more defensively when valuations seem expensive and vice versa.”
The S&P 500 index of US shares presently trades at a price to earnings multiple of 24 times earnings, compared with an historic average of 14 times earnings, and many other developed equity markets also look to be expensive in valuation terms.
Mr Bell said equities can continue to offer value for investors, as the rally in the asset class over the past decade has been driven by a relatively small number of equities, most of which have the characteristics of growth stocks, while stocks displaying more value characteristics have underperformed and in many cases trade at cheap valuations.
The long-term average price to earnings ratio is 18 times earnings, with the market presently trading at about 16 times earnings, meaning UK shares look, on the surface to be quite cheap.
Mr Bell said there is justification in taking the view that buying the cheapest assets adds defensiveness to a portfolio.
He said this is because if an asset class is already trading at a valuation that is low relative to history, then the bad news that could afflict other asset classes will have less impact on a market that trades at a valuation that already reflects the bad news.
Mr Bell said the UK equity market has defensive characteristics both due to the nature of the stocks listed in the UK and the relative cheapness of the valuations.
Mr Krishnan said he can see the attractiveness of UK equities for defensiveness purposes, but is eager to avoid Eurozone shares.
He said a major problem with those equities is the fate of the European economy is strongly linked with that of the rest of the world, so in the event of a global economic slowdown, the European shares are likely to perform at least as badly as those of the rest of the world, and so not offer defensive exposure.
He said that historically Japanese shares have performed well when the rest of the world is in turmoil and may have defensive characteristics.
Simon Evan-Cook, multi-asset fund manager at Premier, is sceptical about the sustainability of both bonds and equities.
His answer, when seeking exposure to assets that have defensive characteristics is to buy funds that can both go long, that is buy investments the managers believe will rise in value, and short-sell.
Short-sellers profit by betting that a particular share will fall in value, and Mr Evan-Cook believes this ability to profit in a falling market represents the chance to profit even in times of market stress.
He is more cautious on the merits of many of the funds, such as absolute return funds, that have sprung up since the financial crisis with the stated aim of “delivering a positive return in all market conditions.”
Mr Evan-Cook’s view is those funds operate by trying to forecast what is going to happen next in the global economy, something which he said is “down to luck.”
Mr Krishnan had a different reason for being cautious on those products. He said in the past he found the “pricing to be unreaslitic”, but he said the fees charged by those funds have started to come down, and so in recent times he has begun to invest more in those funds.
He said absolute return strategies are “uncorrelated” with the performance of the wider market, and he has, in particular been investing in absolute return bond funds, as a way to get exposure to fixed income assets even as markets are highly valued.
Mr Bell said macro funds showed during the financial crisis a decade ago they can perform well in times of market turbulence.
House View: 10-year forecasts: our expectations for returns from the major asset classes
Our forecasts for the next ten years show returns from market indices will continue to undershoot investor’s expectations.
By Riaz Fidahusein, ead of Strategic Allocation, Multi-Asset and Keith Wade, Chief Economist and Strategist.
We have developed fresh forecasts for absolute returns across asset classes for the next ten years.
These forecasts suggest that cash returns are likely to remain poor, and indeed look set to be negative in Japan.
We forecast the UK to deliver the highest cash returns, though even here the projection is for just 1.1 per cent per annum, less than expected inflation of 2 per cent.
These projections chime with our inescapable truths for the next decade, where we argue that interest rates will remain low, albeit not at the exceptionally low levels of the post financial crisis period.
Turning to fixed income, we do expect sovereign bonds to outperform cash over the next decade but returns are likely to be disappointing, and still negative in Japan. We forecast US Treasuries to return 2.7 per cent p.a.
Higher returns can potentially be found in emerging markets, where we see local currency sovereign bonds returning 6.5 per cent.
Our equity market forecasts are based on the rolling excess of annual returns of US equities over US bond yields since 1900, the long run risk premium. This is combined with a valuation measure – the cyclically-adjusted price to earnings ratio, or CAPE.
We see global equities returning 6.7 per cent p.a. and emerging market equities 10.0 per cent. The more generous potential return of emerging markets would typically be expected to compensate for greater volatility and sharper drawdowns. For Europe, we expect returns of 5.1 per cent p.a. and for the UK, 4.6 per cent.
Equities are expected to outperform cash and bonds. However, these forecasts show that there continues to be a gap between the returns stock market indices are likely to deliver, and the returns investors expect.
Our 2018 Global Investor Study found that the typical investor was expecting returns of 9.9 per cent p.a. over the following five years. The implication is clear: there will be greater need for active fund managers who can generate alpha – i.e. who can beat the market – in the coming years.
Finally, looking at alternatives, private equity offers the highest returns on our forecasts.
Riaz Fidahusein, head of strategic allocation and multi-asset and Keith Wade, chief economist and strategist at Schroders