The last 10 years have been especially challenging for investors in risk assets, notably the equity market. The traditional expectation of the 1980s and 1990s was that equity investors were compensated with higher returns for taking more risk than investors in other asset classes such as bonds and cash.
However, since the year 2000, after the dot-com bubble burst, this has not really been the case. The last decade or so has been unusual, having been punctuated by two particularly severe recessions leading to a protracted drop in investor confidence.
The 2008/09 recession was arguably the worst the world has seen since the Great Depression of the 1930s and, whilst we are three and a half years on from the market low point of March 2009 (with global equities having risen almost 75 per cent for US dollar investors from that trough, as measured by the FTA World Index) the aftermath of the credit crunch continues to impact on sentiment. This has brought about a more short-term focus driven by macro issues, more significant price volatility and a preference for ‘safe haven’ investments.
Against this background, at the end of August 2012, global equities in dollar terms had risen 4.4 per cent in capital terms over one year and 17.0 per cent over three years. However over five years investors have still lost 17.1 per cent of their capital, according to the FTA World Index ($). Over ten years, the index has risen 61.9 per cent. This highlights the volatility that can be suffered by equity investors over different periods of time and reminds us that significant equity investment is only suitable for clients who have extended investment time horizons.
It is universally recognised that diversification is crucial to good portfolio construction and we certainly uphold this as a key tenet in providing advice to clients. In the latter stages of the last equity bull market, before the credit crunch, many market commentators were promoting a view that fast developing economies like China would ‘decouple’ from the West and continue to grow apace even if the US and Europe went into recession.
The experience of the last few years has meant this view has been firmly discredited. Equity investors who sought to avoid a US correction by investing in China in 2008 did not escape – correlations across different equity markets ran very high and developing markets now appear to be slowing down in the wake of the West.
Effective diversification requires a mix of different asset classes, no matter where one’s focus has been in the past. At the other end of the scale from the equity market and to avoid volatility, many investors have understandably retained significant cash weightings, despite the fact that the collapse in interest rates in the West means that cash deposits yield virtually no return. Furthermore, our outlook suggests that interest rates will remain low for many months to come.
The problem with holding cash comes in the form of inflation, which although low, is persistent. In real terms, depositors are losing money on cash as the purchasing power of their capital falls. This is a serious problem, particularly for the western consumer whose household expenditure is in large part driven by annual increases to the cost of services. We believe that a negative real return on cash is too high a price to pay for psychological security.
Provided that the cash is earmarked for investment and not required for short term liquidity, our advice to clients is that other asset classes should be considered. Recent analysis conducted by Barclays Capital suggests that the longer you hold cash the more likely you are to underperform equities. The study concludes there is only a 34 per cent chance of cash outperforming equities over two years and this drops to 25 per cent after five years. In short, cash is useful as a tool for tactical asset allocation during short term bouts of volatility but a broader exposure to different asset classes might be considered.
Alternatives to cash
Whilst the world economic environment remains uncertain, what does one recommend as an alternative to cash? Most advisers would say that bond markets, primarily government bond markets, have traditionally been the asset class of choice for investors seeking a better return than cash but less risk than the equity market. US, UK, German and other government bonds have benefited from massive inflows over more than the last decade thanks to a perceived safe haven status.
Latterly, this has been fuelled by the vast expansion of western government debt as successive quantitative easing programmes have been required to rescue the banking sector and reinvigorate the commercial loan market. The result has been a collapse in government bond yields to record lows as demand has driven prices ever higher.
The US Treasury 10 Year bond now yields only marginally more than 1.5 per cent. We would suggest that, although the safe haven status is an alluring concept, many core government bond markets now appear expensive against historic metrics so that there is increased risk to investors seeking capital protection and very limited appeal to investors seeking income. On the other hand, until interest rate increases are widely anticipated a significant correction is unlikely.
Inflation-linked government bonds potentially provide an alternative with less risk to capital as pricing is dependent on the inflation rate, which we expect to remain positive in most regions, avoiding the corrosive effects of deflation. So far, other than for those bonds with the shortest maturities, the implied inflation rate is still reasonably low so that valuations do not appear stretched.
The trade-off is lower coupons compared to the conventional bond market but unless high levels of income are of paramount importance investors might still want to consider shifting some of their focus on conventional government debt to inflation-linked issues.
For investors who are prepared to take a little more risk, we believe there are rewards. Investors are able to gain exposure to the corporate sector using two routes: debt and equity. Corporate debt investors have already benefited as bond yields have collapsed but this asset class still presents some benefits, particularly to income hungry clients who are in a position to accept a little more risk than that traditionally inherent in the government bond market but are unwilling to be subjected to equity market volatility. Although corporate bonds are of course vulnerable to interest rate risk, investors who buy at, or below, par are able to limit the risk to their capital.
As I have suggested above, the equity market has suffered a crisis of confidence over the last decade; however there remain attractive opportunities for investors who have the appetite and capital strength to endure the volatility. From a macro perspective, concerns remain about the growth prospects of the US, with the so-called ‘fiscal cliff’ looming at the end of this year and the shadow of political uncertainty with the forthcoming Presidential election. In Europe, some of the core countries are just about clinging on to positive GDP growth but the eurozone economy remains acutely hampered by the Mediterranean economies, where balance sheets range from severely strained to completely bust.
In Asia and other developing markets, the structural positives of demographics, capital expenditure and export power remain undeniable but concerns about the current slowdown in China after a decade of double-digit growth could get worse still. Overall, equity markets appear relatively inexpensive and, generally, cash flow is strong and corporate balance sheets are in good health. There are definite attractions for those who can take some risk to investing in globally diversified companies with first class brands, capable of paying a growing dividend.
Beyond the traditional asset classes discussed above, there are viable alternatives, which warrant some consideration and, for many investors, these can be employed usefully in a portfolio to provide returns which have a low correlation to equities and bonds and which thereby might enhance the portfolio return at a reduced level of volatility.
In practice this is difficult to achieve and therefore investor suitability considerations are, as ever, of primary importance. ‘Alternatives’ encompass a broad range of different investments but gold and hedge funds fit into this category. Gold is the best performing asset of the last decade, with the price having risen from $288 to $1,690 (or nearly six times) since the start of 2000. Despite this meteoric rise, we are inclined to recommend some exposure to gold thanks to its special status as a safe haven from the fluctuations in the value of paper currency.
Hedge funds have all manner of different objectives. Although they can provide access to some of the world’s leading investors, we advise our clients to take extra care to ensure their own objectives are met. A good up-to-date knowledge of the manager is essential as well as the willingness to accept higher fees and lower liquidity which are part and parcel of this industry.
All in all, we believe that after the many difficulties already suffered by investors over the last ten years or so, there remains significant uncertainty about the global economy and volatility in markets.
However, on balance, our assessment is cautiously optimistic and suggests that investors may like to review their cash balances and, where appropriate, consider the alternatives for improving risk adjusted returns to their portfolios over medium and longer term.
It is essential to seek professional advice before applying the contents of this article.