Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 421

US rate rises would challenge multi-asset diversified portfolios

The Reserve Bank of Australia (RBA) Board surprised the markets at its August meeting by continuing with the scheduled reduction in bond purchases announced in July. It had been thought that the COVID-induced lockdowns and inflation outlook would push the Board into formalising a delay. The relative sanguinity of the RBA Board can be attributed to a number of factors.

First, as the RBA Governor noted in his statement “the experience to date has been that once virus outbreaks are contained, the economy bounces back quickly”. Additionally, the recovery from the pandemic has to date exceeded expectations.

Second, in the context of what looks to be an interruption to growth from current lockdowns, it is not going to be meaningfully attenuated by delaying for a month or two a decision to taper bond purchases by $1 billion a week from September. Other approaches are more effective.

Third, the Governor noted, the “recent fiscal responses by the Australian Government and the state and territory governments are also providing welcome support to the economy at a time of significant short-term disruption.” Of course, one hopes that such measures are intelligently crafted and targeted. Regrettably that hasn’t always been the case.

Flexibility the key differentiator

Most important is the emphasis given by the RBA to its 'flexibility'. This flexibility is a key differentiator between the RBA and some other central banks who have appeared to foreshadow policy rate increases in 2022. Given the uncertainties ahead, the RBA has done well to avoid any such undertaking, even if it has been of a conditional nature in other jurisdictions.

In other words, if the situation deteriorates the RBA has already communicated that its process allows it to quickly flick the switch and increase bond purchases.

For this reason, it would be a mistake to see the August RBA Board meeting as an indication that the RBA was following the lead of other commodity-intensive economy central banks such as the Bank of Canada, the Norges Bank and RBNZ or even the Fed ‘dot plot’ in indicating a significant retreat from historically high levels of monetary accommodation, including policy rate increases in 2022.

The RBA’s expects that the condition (or ‘outcome’) for any increase in the policy rate “will not be met before 2024".

In this context, the RBA is best viewed as a ‘caged dove’ (a 'dove' is defined as a central banker who generally favours easy monetary policy).

That will likely persist, at least until the RBA gets some clarity on the US Federal Reserve’s (the Fed’s) approach. It is the Fed’s approach to inflation that looms large as a challenge for investors.

Certainly the Fed has commenced “talking about talking about” tapering, and strong economic data and clear inflation pressures are likely to escalate that chatter turning the Fed into a ‘reluctant hawk’ (and 'hawks' generally favour tighter monetary policy).

Investment portfolio diversification

It may be for investors that any escalation of tapering talk, particularly given clear and present inflation danger, necessitates a questioning of portfolio diversification practice, including the assumed negative return correlation between bonds and equities.

As the chart below shows, in the period beginning with the ‘tech wreck’ at the turn of this century, bond and equity returns have been negatively correlated. In essence, once inflation had been purged, any periods of stress in the outlook for economic growth and associated downdraft in equity markets could be quickly addressed by easier monetary policy (lower interest rates and lower bond yields).

However, with bond yields at historic lows, and policy rates approaching the ‘zero-bound’, it is reasonable to question whether yields can go meaningfully lower, particularly given inflation pressures, and what that might imply for the diversification properties of high credit quality nominal government bonds, particularly as long-dormant inflation pressures emerge.

If, in the wake of persistence in inflation, the Fed has to jam down hard on the monetary brakes, leading to sharp upward movements in bond yields, there may well be a significant correction in equity and bond markets.

Multi-asset investing implications

Such a scenario looms as a major challenge for investors, including how multi-asset investors react to a potential reversal of long-held assumptions regarding asset return correlation. That is equity returns and bond returns become positively correlated in the worst possible way  - in extremis, both deliver negative returns.

Clearly the search for differentiated portfolio exposures uncorrelated with conventional equity or bond returns looms as a particular challenge.

In the defensive space, inflation-linked bonds or absolute return or  ‘unconstrained’ bond funds are worth consideration. Gold may also be a candidate but its traditional role as an inflation hedge is undermined somewhat by rising bond yields increasing the opportunity cost of holding gold.

If the RBA lags the Fed, which seems likely, then the Australian dollar (AUD) is likely to come under some pressure which may ameliorate any negative performance of unhedged global exposures.

One thing is clear, even if the RBA remains a ‘caged dove’, emerging inflation may cast the Fed as a ‘reluctant hawk’, heralding a requirement for investors to think more imaginatively about portfolio diversification.

 

Stephen Miller is an Investment Strategist with GSFM, a sponsor of Firstlinks. He has previously worked in The Treasury and in the office of the then Treasurer, Paul Keating, from 1983-88. The views expressed are his own and do not consider the circumstances of any investor.

For more papers and articles from GSFM and partners, click here.

 

RELATED ARTICLES

A tale of the inflation genie, the Fed and the RBA

It's not all about interest rates: give me a 1980s petshop galah!

Ian Macfarlane on central bank policies, inflation and China

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Let's make this clear again ... franking credits are fair

Critics of franking credits are missing the main point. The taxable income of shareholders/taxpayers must also include the company tax previously paid to the ATO before the dividend was distributed. It is fair.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

Latest Updates

Investment strategies

Joe Hockey on the big investment influences on Australia

Former Treasurer Joe Hockey became Australia's Ambassador to the US and he now runs an office in Washington, giving him a unique perspective on geopolitical issues. They have never been so important for investors.

Investment strategies

The tipping point for investing in decarbonisation

Throughout time, transformative technology has changed the course of human history, but it is easy to be lulled into believing new technology will also transform investment returns. Where's the tipping point?

Exchange traded products

The options to gain equity exposure with less risk

Equity investing pays off over long terms but comes with risks in the short term that many people cannot tolerate, especially retirees preserving capital. There are ways to invest in stocks with little downside.

Exchange traded products

8 ways LIC bonus options can benefit investors

Bonus options issued by Listed Investment Companies (LICs) deliver many advantages but there is a potential dilutionary impact if options are exercised well below the share price. This must be factored in.

Retirement

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

Investment strategies

Three demographic themes shaping investments for the future

Focussing on companies that will benefit from slow moving, long duration and highly predictable demographic trends can help investors predict future opportunities. Three main themes stand out.

Fixed interest

It's not high return/risk equities versus low return/risk bonds

High-yield bonds carry more risk than investment grade but they offer higher income returns. An allocation to high-yield bonds in a portfolio - alongside equities and other bonds – is worth considering.

Sponsors

Alliances

© 2021 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.