Dusting off the old textbooks, we see time and time again the case being made for a diversified portfolio of assets. The main rationale being that a diversified mix of assets helps to dampen volatility. This was a point the Nobel Prize laureate, Harry Markowitz, is said to have made by describing it as "the only free lunch" in investing. So far this year, investors are unlikely to see it that way.
A well-known model is the "60/40" approach, namely investing 60% in equities and the remaining 40% in bonds. This model has been useful over the past few decades. The reason for a mix between both, and of this magnitude, is that equities are your assets that provide your portfolio with growth opportunities, while bonds help cushion the portfolio when we approach recessionary environments as central banks cut interest rates to stimulate the economy.
Let us look at some historical examples. In 2008, when the world was grappling with the financial crisis, the equity market (as measured by the MSCI World Index[1]) fell by 38.8%, while bonds (as represented by the Bloomberg Global Aggregate Index[2]) rose by 7.6%. Hence, we can see that Markowitz had a good point at the time. So far this year (up to the 22nd of June), the same indices fell by 19% and 10% respectively. In essence, both bonds and equities moved in the same direction, meaning the diversification benefits we have come to expect has not occurred. So, the questions then arise: why hasn’t the model worked? Can we expect it to work going forward?
The main factor that has been driving markets this year is inflation, and central banks’ response to it. Inflation has remained higher for a prolonged period of time, owing to several reasons. Namely, a large part of the labour force retired early because of the pandemic, the Russian invasion of Ukraine which has pushed both food and energy costs materially higher, and the continued lockdowns in China as they grapple with further waves of COVID-19. While these are very different and unique circumstances, what they all have in common is that they continue to put pressure on supply chains. Supply chains were already facing challenges given a shortage of computer chips, which helped to push secondhand car prices materially higher. As the labour market remains tight, employees are demanding increases to keep up with the rising cost of living. This in turn has fuelled fears that wages and prices will keep chasing each other higher, something central banks consider highly undesirable. Their target is longer-term, sustainable inflation. This so-called "wage-price spiral" could un-anchor inflation expectations and as such they are embarking on the fastest pace of tightening in decades. With interest rates moving quickly higher, bond markets have repriced towards the expected level of central bank tightening. Equity markets have had to adjust to higher bond yields and stickier inflation. This has caused a reassessment of how much investors are willing to pay for their future expected earnings.
If central banks are successful at bringing down price pressures, then we can expect to return to a regime where bonds protect portfolios when growth falters. According to central bank projections, they are looking to bring interest rates towards what they call "restrictive" levels. This means that they expect to reduce interest rates in the future when they feel "demand" is more closely matched with "supply" (read last week’s article for more). As such, if we do get a recession, then interest rates can move lower to stimulate demand. Therefore, it seems we are moving back towards conditions where the "60/40" portfolio may become useful again. We would clarify that investors should be cognisant of how they go about investing their bond portfolio. The classic bond benchmark (Bloomberg Global Aggregate Index) contains exposure to investment grade-rated global government bonds, government agencies, corporate and securitised debt. What is not included in the benchmark is floating rate, non-investment grade debt and inflation-linked bonds. If one is contemplating holding the entire position to lean against growth, without considering the higher yield available in corporate debt, then holding a large portion in government debt will be more defensive. Looking back at the 2008 example, the Bloomberg Global Aggregate Treasuries Index[3] returned 11.45%, while the Bloomberg Global Aggregate Corporate Bond Index[4] fell by 3.8%.
To conclude, we see good reason to believe a diversified approach between bonds and equities remains a sensible strategy, but we would advocate being nimble within the bond allocation in order to ensure that investors are best placed to exploit opportunities as and when they arise.
[1] hedged to GBP
[2] hedged to GBP
[3] hedged to GBP
[4] hedged to GBP
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