Are equities and bonds the only games in town?

Diversify, diversify, diversify. Equities, bonds, cash (and maybe a little gold and property). For decades, diversification has been the asset allocation mantra recommended to private investors.

The primary reason is that diversification should provide some balance to a portfolio and a degree of protection against losses from one or more asset classes. In a classic case, when bonds rise, equities fall, and vice versa. Cash is a buffer against both.

But the experiences of the past eight years since Lehman Brothers went bust and heralded the global financial crisis have turned that wisdom on its head.

Central banks have injected multiple sums of new money, amounting to around $80 trillion (£72 trillion), into the financial system to stimulate growth and inflation. This rising tide of new money has floated most boats, particularly bonds, equities and property, but not cash.


This has meant that investors who have followed the diversification mantra have had a double whammy of gains from the two major asset classes in recent years.

That is neatly encapsulated in chart 1 (below, click to enlarge), which shows that the total return (with income reinvested) for both UK corporate bonds and UK equities has been a meaty 101 per cent since October 2008.


UK government bonds (gilts) are behind these asset classes. But they have returned 79 per cent, so it would be difficult to call this historically lower-risk asset class a laggard.

As for cash, had you rolled over the average one-year fixed-rate savings bond from year to year, you would have made 14.4 per cent.

What I seek to show is that investors are in danger of being lulled into believing there has been a sufficiently long track record of strong returns from both equities and bonds for this happy state of affairs to continue.

uk-bond-and-equity-indices-performance-in-twenty-sixteenThat is not likely to be the case. Already we are seeing some cracks in Fortress Fixed Interest. UK 10-year government bond yields, which reached a record low of 0.5 per cent in August, have doubled in the space of two months to just over 1 per cent (bond yields rise when prices fall).

For UK bond investors there appears little cause for concern yet. In the year to date, the three relevant indices (see chart 2, above right) are up between 12.7 per cent (gilts) and 14.5 per cent (equities), with corporate bonds in the middle.


uk-bond-and-equity-indices-in-us-dollarsHowever, for global investors the picture is less rosy. In chart 3 (right), using the US dollar as a proxy for international investors, those sterling gains have not been available to global investors - the indices are down between 3.2 per cent (UK equities) and 4.7 per cent (UK gilts) as at 10 October.

It is the recent weakness of the fixed-interest market that is flashing red warning signs. In the past month dollar-based investors have lost more than 10 per cent from UK fixed-interest securities.

There seem few reasons to expect a turnaround in fixed-interest fortunes, for either UK or global investors.

First, the murky waters of post-Brexit vote Britain have become a little clearer, following prime minister Theresa May's announcement that the government will trigger Article 50 - which sets the two-year clock ticking to actual Brexit - no later than March 2017.

May has also made it clear that the government's primary negotiating position will be to control UK borders and curb EU immigration - likely leading to the 'hard Brexit' that global businesses and markets fear.

Second, sterling's rapid descent to a 31-year low against the dollar means the UK will start to import inflation, which is the enemy of fixed-interest securities.

Sonali Punhani, economist at Credit Suisse, says: 'Our projections show consumer prices index (CPI) inflation rising from 0.7 per cent in 2016 to 2.3 per cent in 2017 and 2.5 per cent in 2018, with sterling constant at $1.20.

'In the extreme scenario of [sterling] dropping to parity, our projections for inflation rise dramatically, with CPI inflation reaching 2.8 per cent in 2017 and 3.4 per cent in 2018.

'In this scenario, the Bank of England is likely to worry about inflation being excessive and rethink the current level of monetary accommodation.

'This will be especially true if we get a big fiscal stimulus in the coming months, which should reduce the pressure on the Bank of England to maintain an accommodative stance.'


Gilts are also under pressure because the 'big fiscal stimulus' that Punhani alludes to is expected to be announced in chancellor Philip Hammond's first Autumn Statement on 23 November.

Hammond has, in effect, ditched his predecessor's commitment to balance the books by 2020. Instead, he is expected to announce increased government spending on infrastructure, housing and other measures designed to boost economic activity.

All of this costs money that investors at large will have to pay for by buying government bonds, particularly as it is widely accepted that tax revenues will fall as Brexit is ushered in.

So you can understand why, given that the government has ditched its commitment to fiscal rectitude in this uncertain economic climate, bond investors will demand more for their money than the current rates on offer.

In short, the deteriorating outlook for sterling, inflation, the economy and the government's borrowing requirements will heap pressure on both UK corporate and government bonds.

The silver lining, for savers, is that the Bank of England will, eventually, be forced to raise interest rates in response to rising inflation and possibly also to make sterling-based assets more attractive to foreign buyers.

The change of sentiment towards UK fixed interest in the past month could be seen as an early warning that the rising quantitative easing (QE) tide that has floated all those boats has reached its peak.

Eight years of strong growth in both fixed-interest and equity markets, which has been a global phenomenon throughout developed markets, has led to increasingly stretched valuations that cannot be sustained ad infinitum.

This situation has led global investors to question whether bond markets are functioning properly. Paul Singer, head of the $28 billion hedge fund Elliott Management, reckons the global bond market is broken and that negative bond yields are a manifestation of 'the biggest bond bubble in world history'.

In a letter to the fund's investors, he warned that 'the ultimate breakdown (or a series of breakdowns) from this environment is likely to be surprising, sudden, intense and large'.

Singer penned that note back in July, since when, barring recent events in the UK market, the bond market bubble has arguably grown bigger still.


Other asset managers are sounding a note of caution. One is Mark Burgess, global head of equities at Columbia Threadneedle. In a recent commentary entitled 'Easy Money - could the cure be more damaging than the illness itself?', he notes that global asset valuations continue to be underpinned by QE.

'But it is clear that central bank stimulus, and in particular the European Central Bank's bond-buying programme, is distorting global markets,' he says.

Although he does not make any major changes to the firm's asset allocation model, one comment from Burgess sticks out. He remarks that 'clearly, we are reluctant owners of equities and credit [corporate bonds] in these markets'.

In the marvellous film The Big Short, the main characters saw the seeds of the global financial crisis sprouting in the US housing market long before the denizens of Wall Street, the City and Frankfurt.

They made handsome profits, eventually, but nearly went bust in the process, as they battled against blinkered markets and investors who questioned their sanity.

These real, pre-financial crisis characters have post-crisis equivalents today - and no one is a better match than the UK's Crispin Odey.

Investors in his $8.8 billion flagship hedge fund, Odey European Inc, have had to swallow losses of 35 per cent in the year to the end of August, and dire performance over the previous three years.

This is due to the fund persisting in pursuing a strategy designed to be hugely profitable when and if the veneer of QE starts to fade (here it is worth pointing out that the sterling share class of Odey's fund returned 89 per cent between October 2007 and October 2009).

Of the many possible choices among Money Observer's Rated Funds, I've highlighted four that could weather a QE-inspired storm better than most.

These are Investec Global Gold and the investment trust Bacit in the specialist asset group; Capital Gearing, which is among the lower risk mixed asset choices; and the sterling-hedged share class of the Schroder ISF Global Inflation-Linked Bond fund, a global bond choice that will benefit from rising global inflation expectations.

When the day of reckoning finally arrives, one hopes bonds and equities will not fall as far as they have risen over the past eight years.

But for investors with an eye on the short to medium term, having meaningful exposure to cash and gold is more likely to provide the diversifying cushion that traditional asset allocation models suggest it should.

Such exposure is certainly a more reliable diversifier than holding only equities and/or bonds.

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