The New Economy: Flexibility is Key
Updated: May 20, 2022
Real returns from equities since 2000 have been very disappointing. Looking forward, we are more likely to see the potential for poor real returns from bonds, in light of historically low real long-term yields. Funds that have high and fixed allocations to these asset classes have struggled in recent years and will likely continue to struggle.
"Property, infrastructure, commodities, hedge funds and total return fixed income funds can perform well in a rising inflation environment"
It is time to move away from static allocations linked to some composite benchmark towards more flexible structures that are able to better navigate fluctuating markets. The 1980s and 1990s were great decades for both bond and equity investors, with real returns from both substantially above their long-term averages. The reason for this was falling inflation (good for bonds and equities) in combination with strong economic growth (good for equities).
China’s entry into the global economic arena allowed goods to be manufactured more cheaply, in the process freeing up labour in the developed world to focus on service industries (such as construction, finance, healthcare) that would otherwise have been inflationary (it should be noted that the internet has also been a very deflationary force).
These conditions drove equity valuations to absurd levels, and the 2000s have seen the asset class hit badly; first by the bursting of the tech bubble, and then by the GFC. For example, the price to book value ratio of the S&P 500 in 1981 was 1.3 times. Over the following 19 years it rose to over 5 times, driven by falling inflation and the aforementioned structural forces. The bursting of the tech bubble in 2000 and subsequent fallout in 2001 took equity valuations down to around 2.8 times book, where they stayed, roughly speaking, until the GFC reduced them to 1.8 times. The equity market recovery since 2009 has brought the ratio back up to around 2.5 times, close to its long-term average.
The same pattern with respect to both the 2000-1 and 2007-8 market declines was evident in markets all around the world. As a result, returns from growth-oriented multi-sector funds were very poor during the 2000s. From June 1993 to June 2000 funds in Morningstar’s OE Growth Sector universe achieved real returns that averaged 8.8 per cent per annum, but just 1.4 per cent per annum in the 13 years since.
From 1993 until the GFC, rolling five-year real returns averaged 5.3 per cent per annum. The GFC has taken average real returns for the entire period down to just 3.2 per cent per annum. Over 20 years, the difference between CPI+3.2 per cent and CPI+5.3 per cent equates to around 150 per cent of initial capital, a stark illustrati
on of the effect of compounding.
Although the worst may be behind us with respect to equities, the same may not be said for bonds, which continued to perform well in the 2000s as inflation continued to fall. Indeed, the GFC increased – not decreased – demand for government bonds, first from investors looking for a safe haven, then from central banks seeking to drive yields down further in order to stimulate growth. Yields on 10-year inflation-linked bonds in the US, UK, Europe, and Japan fell to between -1 per cent and -2 per cent, levels which suggested extreme over-valuation but could be explained by investors seeking capital stability during a period of
heightened macro-economic uncertainty.
Although Australian inflation-linked yields never turned negative, they nevertheless fell to extremely low levels; the 10-year yield hit a low of 0.25 per cent in July 2012, having averaged around 3 per cent prior to the GFC (it has since increased to 1.6 per cent). The strong credit quality of Australian sovereign bonds and a desire for capital preservation help explain this.
The problems that may lie ahead for bonds are best illustrated by looking at long-term real returns from long-dated bonds in the US. Since the mid-20th century, real returns from US long-dated bonds have averaged 2.8 per cent per annum. However, the period of falling inflation from the early 1980s to now has seen real returns average close to 8 per cent, vastly in excess of what one should expect from investing in long-term government bonds.
What this means, of course, is that future real returns are likely to be below long-term averages for some time and possibly even negative. Exactly how and when this may begin to happen is hard to say – it is possible the bull market has one last leg – but the probability of below-average returns is high.
Indeed, if we see 30-year rolling returns revert first to their long-term average and then to the lower end of their long-term range, the real value of a portfolio of long-term Treasuries could halve. This would be the worst case scenario, of course, and the result of a sustained period of high inflation (and at this juncture the developed world suffers from insufficient inflation, rather than the converse).
Nevertheless, the message is that bond market real returns are likely to be below average for some time. Furthermore, it is unlikely that Australian government bonds would escape the fate of their counterparts in other parts of the developed world since inflation is broadly a global phenomenon.
Rising inflation is clearly negative for long-term bonds, but it is equally threatening for equity returns. Higher inflation creates uncertainty and drives up discount rates, hurting the present value of cash flows from any nominal asset – i.e., bonds, property, or equities – unless there is an explicit link to inflation in those cash flows. Exactly why this is the case is hard to explain (unlike bonds, where the impact of inflation is obvious), but there is a reasonably strong correlation between the rate of inflation and dividend yields.
The best explanation is that high inflation tends to reduce real earnings growth but also increases the equity risk premium. Equities can provide a hedge against inflation via nominal earnings growth, but this is tempered by falling valuations. There is a negative correlation between the performance of theoretical US balanced funds (a blend of 50 per cent equities and 50 per cent Treasuries) and inflation, though it is only apparent over longer time frames.
If both bonds and equities are going to struggle at times as inflation rises, it will be important to limit one’s exposure to them. One can do this in two ways: diversification and dynamic asset allocation. Even if returns from equities and bonds are going to be below long-term averages, this does not mean that one cannot find other asset classes or investments that will perform well.
Although one may have to sacrifice some liquidity, ‘alternatives’ such as property, infrastructure, commodities, hedge funds and total return fixed income funds – investments that do not contain much equity or bond ‘beta’ – can perform well in a rising inflation environment.
It is important to note, however, that if inflation doesn’t rise then of course the outlook for bonds (and equities) will be brighter. Also, one should always consider the insurance qualities of fixed income; this asset class can be held as a hedge against falling equities.
So there will still be times when owning bonds will make sense, but what we are unlikely to see is a repetition of the scenario that has played out over the last 30 years when it made sense to hold bonds on a virtually permanent basis.
Dynamic asset allocation (DAA) will also help in navigating a period of low equity and bond returns. Unlike a strategic/ tactical approach, in which one over- or under-weights equities or bonds relative to a composite benchmark, dynamic asset allocation is much more flexible, allowing one to dramatically reduce weightings to these asset classes, possibly even to zero.
Although the DAA process does not have to be systematic, one can best illustrate its benefits by considering a strict invest-divest rule based on price-to-book ratio. Vastly reducing equities when they are trading above 3 times book value and buying back below 1.5 times is a strategy that has worked well in both Australia and the US (and very likely in other markets too). Furthermore, by avoiding equities when they are de-rating, and investing in them heavily when they are cheap, one also reduces fund volatility.
Perhaps most importantly, DAA does not have to be about taking large positions all the time. In the case of Australia, only four years out of 23 would have required a fund using DAA to look very different to a static balanced fund. Looking forward, a fund may require more activity, but it is still likely that for much of the time a fund that uses DAA will look more like a traditional balanced fund.
But although this may be the case, a fund using DAA will be able to shift the portfolio allocation when necessary; it is not bound by a static asset allocation; and it is this that can enable the fund to mitigate risk in turbulent markets.
In conclusion, real return funds that target a certain margin above inflation, as opposed to performance relative to some composite benchmark, should not be seen as complicated beasts.
There will be periods when the best strategy for them to follow will be similar to that of a traditional balanced fund. Their strength, however, is in relation to their unique features; namely their ability to diversify into alternative asset classes as well as to, at times, dramatically increase or decrease equity and bond exposures.
Published in Money Management Australia
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.