13 March 2019
By Sheldon MacDonald, Co-Fund Manager HC Verbatim Multi-Index Funds
For much of the current decade, all the main asset classes have been rising. Between September 2010 and September 2018, UK shares rose by more than 90%, commercial property more than doubled, corporate bonds gained more than 50%, and even low-risk government bonds rose by more than 40%.
These strong performances were driven by quantitative easing (QE) and low interest rates, which were efforts by the Bank of England to inflate asset prices, with the hope that the benefit of these rising values would trickle down into the economy. Across the pond, during this period the US Federal Reserve (Fed) seemed to step in with accommodative policies at any sign of market weakness. This came to be known as the ‘Bernanke Put’, a reference to put options that provide protection in the event of market declines. More recently the term has evolved to the ‘Powell Put’, after new Fed chair Jerome Powell indicated a pause in interest rate hikes in December 2018.
This aim of asset price growth was achieved. But it took several years before economic growth followed and it may only be weakly linked to these central bank policies.
Longest bull run
The eight-year period to September 2018 formed part of the longest bull market in history for the US S&P 500 index. In an environment in which all the main asset classes did well, correlations between them rose and there were limited opportunities for diversification. But, when everything is going up, diversification is less of a priority.
Today, though, the game has changed. Economic cycles do come to an end and, while we may not be at the end of the cycle yet, we are certainly closer to it.
Bulging balance sheets
Central banks are keen to raise interest rates, in order to have some monetary ammunition available in the event of a future recession. They could continue to use QE, but the size of central bank balance sheets, due to bond ownership, is already massive across the world. At some point this must be unwound.
The Fed has already given indications about how it might further reduce its balance sheet. But the question now is: if growth does start to slow, would the Fed, perhaps along with other central banks, continue with these plans? After all, doing so in a slowdown could lead to worse outcomes. The great unknown, then, is what central banks will do with their balance sheets and investors must ensure they are positioned to cope with any outcome.
Challenges to global growth
In 2018 we enjoyed broadly synchronised global economic growth (although the US did outstrip most other developed economies). But that narrative is now under threat as economic data points to slower growth than we had previously.
While it is possible to argue global growth currently looks solid, and that moderate inflation can be economically beneficial, economic data does seem to be weakening, just as new challenges have arisen, in the form of quantitative tightening and rising interest rates. So there are new threats and we believe diversification is the best way to deal with them.
Benefits of bonds
This brings us to the issue of correlations. Poor economic growth is a challenge for equities but bonds can perform more strongly in a weaker environment, as inflation typically declines in low-growth periods and interest rates are often reduced to stimulate economic activity. This suits bonds, as the real (inflation-adjusted) value of their fixed coupon payments can look more attractive when interest rates are lower and inflation is relatively benign.
Bonds are no longer at the record low yields we have seen since the financial crisis, although they remain close to these lows. Even so, bonds could perform relatively strongly if equities start to weaken.
To be clear, we aren’t arguing that equities will definitely decline from current levels: as noted above, global growth is still reasonable, and we aren’t necessarily at the end of the current economic cycle. Rather, we believe risks have risen and, in this challenging environment, we think it is vital to be well diversified across both equities and bonds. A multi-asset approach enables allocations across a range of asset classes and can give investors some reassurance that they are not overly exposed to particular economic challenges. This has the potential to benefit investors in the long term.
The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use. This article is for information only and should not be deemed as advice.