Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 309

Where to now for adequate investment returns?

US economist Frank Knight was the first to draw a distinction between 'risk' and 'uncertainty' in his 1921 book, ‘Risk, Uncertainty, and Profit’.

Risk is what many investors in portfolio construction address, using statistics like expected mean returns, standard deviations and cross-asset correlations.

Uncertainty, according to Knight, is when you simply do not know what could happen, when even the basic parameters are unknown.

The impact of new technology in retailing, for example, is not just a risk for the retail property industry, but fundamental uncertainty. In the same way, the fact that global monetary policy is in unchartered waters means that the problem investors face is not just risk, but uncertainty.

Furthermore, risk models may not work if the environment in the future is fundamentally different to the recent past. Therefore, uncertainty and backward-looking risk models in a changing environment are both critical today.

Today’s main 'uncertainty' problem is extreme low rates

Our starting position is unusual and extreme. Balance sheet recessions in the Northern Hemisphere have resulted in the lowest rates in recorded history in the United States, Japan, the Euro zone, and the United Kingdom in this cycle. These extraordinary rates are the result of balance sheet recessions that followed debt-fuelled property booms.

Given that Australia’s residential prices peaked higher than those in the United States, Euro zone and United Kingdom and that Australia’s household debt is higher than household debt in those countries, Australia may also experience a balance sheet recession. Under that scenario, rates will move even lower than they are now, despite the cash rate reduction to 1.25% this week.

There is also the opposite (and recently forgotten) risk of inflation. All of these northern countries have engaged in non-standard monetary theory, such as quantitative easing. In the United States, there is also late-cycle fiscal stimulus and speculation about Modern Monetary Theory (MMT), a new acronym for an old idea: the government printing money to spend it.

The established theory in the 1970s, 1980s, and 1990s was that a combination of large government deficits and money printing was the best way to generate high inflation. Yet the example of Japan, where despite extraordinary fiscal and monetary stimulus, inflation has still not emerged, means that MMT is no longer viewed as the best theory of inflation.

In fact, today, we do not have one agreed theory of inflation, which is why some government officials advocate experiments like MMT. The risk is, of course, that there is no such thing as a free lunch, and that if you print money to spend it, inflation eventually arrives and presents the bill.

Portfolio implications and will bonds defend?

In a world of risk and uncertainty, where can investors go to generate adequate returns?

In recent years, bonds have proved to be a successful hedge to falling equity markets, but this is not always the case.

During the GFC, the 1990 recession and the 1987 stock market crash, bonds provided decent off-setting diversification. When the equity market lost a third its value, the bond market, as represented by the 10-year Australian bond delivered about 19%.

But before the great bond bull market that started in 1983, things were different. In the late 1960s, in 1974 and in the 1980 market downturns, equity markets lost about a third of their value, but bonds lost around 14% of capital value and also recorded a negative total return (see table). Given the starting point, the last 35 years may not be the best guide to the future.

The second concern is that from the current starting point of the Australian 10-year bond yield of 1.53%, (as at 29 May 2019), the gains from bonds will be mathematically limited, considering the yield is already near historic lows.

Today’s problem: bonds do not always play defense

investment returns

investment returns

Source: FactSet, MSCI, Standard & Poors.

Today, the experiences of the last 35 years may not be relevant, with economic models calibrated with decades of past experience perhaps falling into the same trap that caught those valuing mortgage backed securities in 2007.

Think outside the box

If the outlook for bonds is uncertain, asset allocators may have a major problem. Modern asset allocation frameworks are often built on the premise that bonds will act as the defensive part of the portfolio.

Indeed, certain asset allocators may need to re-think their entire portfolio. Equities will have to play a role for the equity yield and the long-term growth. They offer income and inflation protection. However, the benefits come with risks, and some investors may need to think more about their equity exposure and their defensive properties if trouble strikes.

The lesson is that even the growth portion of a portfolio may need to offer defensive properties.

Uncertainty not risk

Risk is often measured on backward looking statistical measures, but this may not offer a guide to the future. The behavior of an asset class at some time in the past, does not mean that it will always behave that way.

In our view, equities are needed for inflation protection and income, and the risk of capital loss from owning equities can be limited by focusing on valuation and more defensive (sustainable yield) equites, given that cash (and not bonds) is the only perfect defensive asset.

 

Philipp Hofflin is a Portfolio Manager and Analyst on the Australian Equity Team with Lazard Asset Management. His views may not represent those of other portfolio management teams at Lazard Asset Management. This article is general information and does not consider the circumstances of any investor.

 


 

Leave a Comment:

     

RELATED ARTICLES

Four checks for a financial fire drill

How risky are bank hybrids and are they misrepresented?

banner

Most viewed in recent weeks

Lessons when a fund manager of the year is down 25%

Every successful fund manager suffers periods of underperformance, and investors who jump from fund to fund chasing results are likely to do badly. Selecting a manager is a long-term decision but what else?

2022 election survey results: disillusion and disappointment

In almost 1,000 responses, our readers differ in voting intentions versus polling of the general population, but they have little doubt who will win and there is widespread disappointment with our politics.

Now you can earn 5% on bonds but stay with quality

Conservative investors who want the greater capital security of bonds can now lock in 5% but they should stay at the higher end of credit quality. Rises in rates and defaults mean it's not as easy as it looks.

30 ETFs in one ecosystem but is there a favourite?

In the last decade, ETFs have become a mainstay of many portfolios, with broad market access to most asset types, as well as a wide array of sectors and themes. Is there a favourite of a CEO who oversees 30 funds?

Betting markets as election predictors

Believe it or not, betting agencies are in the business of making money, not predicting outcomes. Is there anything we can learn from the current odds on the election results?

Meg on SMSFs – More on future-proofing your fund

Single-member SMSFs face challenges where the eventual beneficiaries (or support team in the event of incapacity) will be the member’s adult children. Even worse, what happens if one or more of the children live overseas?

Latest Updates

Superannuation

'It’s your money' schemes transfer super from young to old

Policy proposals allow young people to access their super for a home bought from older people who put the money back into super. It helps some first buyers into a home earlier but it may push up prices.

Investment strategies

Rising recession risk and what it means for your portfolio

In this environment, safe-haven assets like Government bonds act as a diversifier given the uncorrelated nature to equities during periods of risk-off, while offering a yield above term deposit rates.

Investment strategies

‘Multidiscipline’: the secret of Bezos' and Buffett’s wild success

A key attribute of great investors is the ability to abstract away the specifics of a particular domain, leaving only the important underlying principles upon which great investments can be made.

Superannuation

Keep mandatory super pension drawdowns halved

The Transfer Balance Cap limits the tax concessions available in super pension funds, removing the need for large, compulsory drawdowns. Plus there are no requirements to draw money out of an accumulation fund.

Shares

Confession season is upon us: What’s next for equity markets

Companies tend to pre-position weak results ahead of 30 June, leading to earnings downgrades. The next two months will be critical for investors as a shift from ‘great expectations’ to ‘clear explanations’ gets underway.

Economy

Australia, the Lucky Country again?

We may have been extremely unlucky with the unforgiving weather plaguing the East Coast of Australia this year. However, on the economic front we are by many measures in a strong position relative to the rest of the world.

Exchange traded products

LIC discounts widening with the market sell-off

Discounts on LICs and LITs vary with market conditions, and many prominent managers have seen the value of their assets fall as well as discount widen. There may be opportunities for gains if discounts narrow.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.