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Are ‘Safe Havens’ Really That Safe?

Updated: May 19, 2022

In recent years there have been a number of complaints against advisers in which the Financial Ombudsman Service has ruled that the client’s risk appetite was not properly considered. Some of these complaints were upheld even though it transpired that the client had withheld important information.

"A static, balanced portfolio approach during these periods would have been disastrous!"

It is no wonder that advisers often err far too much on the side of caution for fear of being hauled up in front of the ombudsman. As a result it is possible that clients with longer investment time horizons may be ending up with portfolios that are too low risk and thus likely to fall short with respect to investment objectives. More worryingly, it is possible that they are over exposed to so-called safe haven assets such as government bonds which may be in fact be riskier than is generally believed.

Take UK government bonds for example.

Currently, the yield on the 30 year inflation protected Gilt is -0.846% which means that if you buy it today and hold it to maturity you will lose 22.5% of your real capital. In fact there is no risk of this not happening (excepting the British government defaulting). It is guaranteed. Twenty years ago the yield was around 4% which meant you’d make 224% real. Do people really understand the extent of this change? I’m concerned that many don’t.

The US, with its long data history, provides a useful guide to the future. Since 1849, US long bonds have produced a real return of 2.1% per annum. However, there were two long periods (one of 19 years from 1901 to 1920 and the other of 41 years from 1940 to 1981) when real returns were substantially negative: -4.2% and -2.7% per annum respectively. A static, balanced portfolio approach during these periods would have been disastrous!

The reason for the poor performance was not that real yields were rising, though they may well have been. Rather, or mainly, it was because inflation was rising. During the two aforementioned periods, inflation rose from 1.2% to 23.7% and from 0.0% to 11.0% respectively. You still got paid back, but in dollars that were worth an awful lot less.

What distorts current thinking further is that inflation during the last couple of decades has been unusually stable. Go back further and a different picture emerges: for only one third of the time since 1774 has 10-year annualised inflation in the US been between 0% and 3%. So, the chances are that this period of stable inflation will at some point end, though it’s hard to predict when and in which direction it will head.

It is certainly possible given how leveraged the world economy is that we get one last deflationary shock, in which case long bonds may have one last hurrah, but I wouldn’t count on it. Inflation would have to fall substantially to make up for the prevailing negative real yields in the UK.

To put it simply, important risk is the risk of permanent loss of capital, the sort that is currently embedded in the real yields of UK gilts. And yet bonds are generally viewed as low risk because they are low volatility. When inflation starts rising, as it is likely to do at some point, you will see your real capital erode, but only gradually. Consider this low risk at your peril.

But fear not; help is at hand. During the two bond bear markets mentioned earlier, equities in the US did just fine, returning in real terms 7.0% and 4.4% per annum respectively compared with long-term average of 6.4%.

Furthermore, during the three bond bull markets, they did even better, returning 8.4%, 7.2% and 8.7% respectively. Another way of putting this is that if you look over a long enough time frame, it turns out that equities are less risky than bonds!

True, there were some pretty nasty equity bear markets over the last 150 or so years but they didn’t, unlike their bond equivalents, tend to last very long. The fact is that equities have generally exhibited a remarkable ability to recover, principally because companies, unlike bonds, have been able to adapt to prevailing conditions.

Furthermore, dividend distributions have been a lot more stable than you’d think by looking at market movements. The only one of the seven US equity bear markets since 1970 in which aggregate dividends fell was the most recent one, and that was concentrated in one sector: financials.

That equities can be less risky than is generally perceived and bonds more so are findings that will I think prove highly pertinent over the next couple of decades.

Published in Portfolio Adviser

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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