The Final Frontier

Should you significantly alter asset allocations in response to an unknown macro scenario when history demonstrates that equity markets offer the best option for growing the real (post inflation) value of investments?

Graham O'Neill, Senior Investment Consultant, talks about inflation, investment strategy, historical precedents and weatherproofing a portfolio in the latest RSMR world economic and market update.

"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."

Mark Twain

Fully invested

Investing is an art rather than a science and has always embraced uncertainty. Uncertainty, however, does not mean that an investor can't prepare a portfolio for the future and some degree of weather proofing is prudent when exiting a pandemic as there are no historical precedents for what will happen next. While equities have certainly performed strongly in recent years, the earnings yield versus bonds has not really budged and looking at the valuations of all asset classes outside of equities, it's difficult to find investment choices other than equities that are likely to deliver on the aspirations of longer-term savers, especially pension fund savers. In this environment, for those committed to markets for the long run, it may be best to remain more-or-less fully invested unless evidence to the contrary is absolutely compelling.

Taming the inflationary tiger

Investors should also think over their attitude to risk. Equity markets are inherently volatile from time to time and many of the sharp setbacks that have occurred over the last 50 years have not been easy for investors to predict. Some have occurred at times of extreme over valuation by historic norms of equities in absolute terms, which usually happens at times of economic optimism 'justifying' the view in the eyes of the majority that 'this time is different'. In the 1970s, the oil crisis ushered in a period of high inflation which proved to be something most economists found hard to explain, and therefore the success of Paul Volcker, US Federal Reserve Chair, in taming the inflationary tiger through raising interest rates dramatically caught most investors by surprise. Similarly, the Telecommunications, Media and Technology (TMT) bubble, the GFC, Eurozone Crisis, to name but three, have only been forecast by a minority of investors, otherwise the bull market would have ended before these factors impacted on economic fundamentals.

Setbacks & safe havens

When setbacks occur at times of expensive valuations, there is always the potential for these to be severe and fast moving, as was the case in 1987, 2000 and 2008 (where overvaluation was most apparent in credit). Covid-19 was a black swan event and completely unpredictable. While equities show periods of volatility, this is a different thing from risk if it's defined as the permanent loss of capital. Investors should consider how much they are prepared to spend to hedge out volatility risks, for example, in the form of holding low-yielding government or investment grade bonds if they have a truly long-term time horizon. At times of market volatility, the safe haven status of even investment grade corporate debt has not held up as well as investors might expect, as was seen during both the GFC and the Covid-19 pandemic. This isn't always the case in periods of extreme stress when investors need investment grade debt to maintain its long-term low correlation with equities.

A diversified portfolio

Martin Wolf, chief Financial Times economics commentator, has stated that equities have delivered long-term outperformance for investors despite World Wars, a depression, a Global Financial Crisis, and now a pandemic. To deliver security in old age, investors not only need to save for a pension, but save in a manner that will give a positive real return, or in other words, provide a pot of money that grows in value faster than inflation. In today's low-rate world, where the price of safe assets has been distorted by central bank policy, it seems likely that the only sensible way to achieve this is to invest in risky assets. To reduce risk, investors should focus and differentiate between short-term price volatility and the possibility of serious impairment to the value of their capital. Ironically, actuarial considerations have forced many pension funds to move in the opposite direction, not capitalising fully on the post GFC bull market. Empirical evidence backs up this approach with, for example, the work of Elroy Dimson, Paul Marsh, and Mike Staunton in successive Credit Suisse Global Investment year books, demonstrating that for longer than a century, a portfolio of equities has done staggeringly well, especially if diversified globally.

While investors in the UK market in the current millennium, and in Japan since the post 1990 period, have only seen muted returns or worse, those with a truly global portfolio have fared far better. The UK FTSE ended 1999 at a then record high of 6,930 and was below this level during the last Monday of September. However, thanks to the reinvestment of dividend income, nominal returns were positive with an annualised rate of 3.3% until 31st December 2020. In contrast, Wall Street, which was also hard hit in the TMT blow up, has seen the S&P 500 reach around three times its end '99 level. The UK (one of the less well performing markets in more recent times) since 1900 has delivered an average annual real return of 5.4% compared to 6.6% in the US. In contrast, UK government bonds have given an average real return of 2.0% p.a. The argument for investors holding bonds is that in Wolf's words, wars or revolutions can ruin equities, but he adds very importantly, they also destroy the value of bonds (fixed interest securities). For most investors, holding a widely diversified portfolio of equities, especially if combined with the selection of top performing fund managers, offers the best long-term investment strategy even, or perhaps especially, in an uncertain world.

A volatile market

Today, the world is experiencing shorter-term, cyclical inflationary pressures which have led to periods of volatility, especially intra-market in terms of style rotation, something which is masked by overall index levels. The medium to long-term prospects for the global economy suggest that structural forces of debt, demographics, and disruptive technological change will return the world to an era of secular stagnation. While inflationary pressures are likely to prove transitory, the definition of transitory will differ amongst market participants. Supply side problems, many of which are related to Covid-19, look likely to persist for much or all of 2022 and the market will remain volatile until a clearer picture emerges of the path of inflation and interest rates. There is also the question of what the appropriate policy response to supply-side rather than demand-driven inflationary pressures should be. Whether tightening monetary policy would be the correct response is a moot point.

Weatherproofing portfolios

For investors with a sufficiently long-time horizon, prepared to sit through periods of volatility, which history demonstrates is not the same as the risk of permanent loss of capital, there remains the potential to make excellent long-term returns. Investment is also about risk management and extreme over valuation does run the risk of permanent impairment of capital, especially if occurring in narrow areas of the market such as technology stocks in 2000 and Japan in 1989/1990. Even in the US, the 'nifty-fifty' period resulted in the Dow regaining its 1969 level only in 1982. Often investors are over exposed to the most vulnerable parts of the market as these are the most fashionable and over owned which is why valuations are high. This again emphasises why some weatherproofing of portfolios is prudent. In the short-term, the biggest threat to markets remains an inflation scare, even if it does not actually occur. Although a bear market looks unlikely, if 10-year treasury yields in the US saw upward pressure towards the 2% level, this could result in equities suffering a period of volatility.

Asset allocations

Market returns can be augmented by skilled fund selection and, for investors utilising managers who have demonstrated the ability to deliver returns with lower than market levels of volatility, a portfolio with a high weighting to equities remains fully justified. If rising cost pressures impact on company margins and disposable income in 2022, resulting in a second half slowdown, quality equities would likely be the most resilient part of the market. The most significant threat to equity markets today would be a period of sustained higher levels of inflation with cyclical pressures strong enough to overturn today's strong secular disinflationary trends. As it is impossible to predict with any certainty that this is likely to occur, there seems no reason to significantly alter asset allocations in response to a macro scenario which may or may not occur when history demonstrates equity markets offer the best option for growing the real (post inflation) value of investments in most circumstances, a view reinforced by the dearth of valuation opportunities in what are considered to be 'safe assets' and the consistently poor returns from most absolute return strategies.