Investments

Decades-long defensive asset rally looks over

Spotlight October 2016

The case for equities is more positive, with valuations far less stretched than bonds.

Recent patterns of returns are a poor guide to the future, write Mark Rider and Stewart Brentnall.

Looking back at the performance of the major asset classes over the past 20 years, you’ll see the unexpected scenario of global fixed interest being the second-best performing after Australian equities.

Asset class returns (%)

  Annualised return Annualised standard deviation Return to risk ratio
Australian equities 9.0 13.0 0.69
Global equities (UH) 6.0 12.6 0.48
Global equities (H) 6.4 14.6 0.44
Australian fixed interest 6.6 3.1 2.13
Global fixed interest (H) 7.8 2.8 2.79
Cash 4.8 0.4 -

Note: Data for 20 years to September 2016. Sources: Australian shares – S&P/ASX 300 Accum. Index, global developed shares – MSCI World (ex Aus) in $A (hedged and unhedged), Australian fixed income – Bloomberg Composite Bond All Maturities Index, global fixed income: Barclays Capital Global Aggregate Index Hedged $A. Cash: Bloomberg Bank Bill Index (Post Apr 87). JP Morgan Bloomberg as at September 30, 2016.

Extraordinarily, since 1996 the returns from a portfolio of 70 per cent defensive assets (fixed interest and cash) and 30 per cent equities has largely matched the performance of a portfolio with the exact opposite allocations – with about half the level of standard deviation or volatility.

Portfolio returns (%)

Diversified funds Annualised return Annualised standard deviation
Ex-post – 20 years September 2016
Conservative fund (30/70) 7.1 4.2
Growth fund weights (70/30) 7.5 8.7

Sources: Australian shares – S&P/ASX 300 Accum. Index, global developed shares – MSCI World (ex Aus) in $A (hedged and unhedged), Australian fixed income – Bloomberg Composite Bond All Maturities Index, global fixed income: Barclays Capital Global Aggregate Index Hedged $A. Cash: Bloomberg Bank Bill Index (Post Apr 87). JP Morgan Bloomberg as at September 30, 2016.

This unusual scenario has been driven by the massive bond rally that’s occurred since the inflationary peak of the 1970s, leading to defensive assets’ stellar performance. But in our view this scenario is unlikely to be repeated in the decades ahead.

The end of the bond rally is in sight

Over the past 50 years bond yields have experienced an unprecedented cycle. From a low of 4.6 per cent in 1966, US 10-year Treasury bonds rose to a staggering 16 per cent by 1981.

Today, they are a paltry 1.8 per cent, or around a multi-century low. This is in stark contrast to the period from 1876-1970, during which bond yields traded in a much tighter range.

10-year bond yields

Sources: Lazard Asset Management, Morgan Stanley

We believe the future is likely to look a lot more like the century prior to 1970, rather than the two decades we’ve just witnessed. We say this because a number of the factors that have driven bond yields so low are likely to wane in the decades ahead.

In particular, central banks’ unusually frequent and big bond purchases, together with negative short-term interest rates, must end eventually.

We’ve also seen large pools of savings accumulate in emerging markets and in China, which have been invested in bond markets. This trend is likely to reverse as inflation gradually moves higher and savings pools diminish.

Where does this leave investors?

At current global (1.2 per cent) and Australian (2.2 per cent) yields, we believe bonds provide inadequate protection for the next five to 10 years against several risks. These risks include:

  • still soft, but better economic growth
  • somewhat higher inflation
  • a reduction in central-bank bond buying (which would see a sharp drop in demand for government debt).

The case for equities is much more positive, and with valuations currently far less stretched, we believe prospective returns are likely to be similar to that of the past 20 years.

Asset class returns – past and expected

Source: Australian shares – S&P/ASX 300 Accum. Index, global developed shares - MSCI World (ex Aus) in $A (hedged and unhedged), Australian fixed income – Bloomberg Composite Bond All Maturities Index, global fixed income: Barclays Capital Global Aggregate Index Hedged $A. Cash: Bloomberg  Bank Bill Index (post Apr 87). JP Morgan Bloomberg as at September 30, 2016, Mercer.

Greater risk required

The key message for investors is that they may need to take on greater risk to generate similar long-term returns from a diversified portfolio as we’ve seen in the past 20 years – or lower their return expectations.

Importantly, bonds still have a critical role to play in the diversification of portfolios, given they typically perform well when growth assets such as equities perform badly. However, with yields at such low levels, their capacity to do this is significantly reduced.

As always, our focus will be on balancing the risk and return characteristics of our portfolios so they can successfully deliver on their long-term objectives.