Investing involves the risk that your capital goes down as well as up; you may get back less than you invested. The commentary below is not intended as a recommendation for you to personally buy or sell any of the investments mentioned nor to take any investment action whatsoever.
It was just over a year ago that I last wrote a ‘market update’. In many ways, not a whole lot has changed since then. In short, the relatively positive view we expressed in Sept 2022 has proved to be correct. So what happens next?!
I think the answer to that question depends on the interest rates offered by government bonds and inflation. Note that this is distinct from the central bank’s benchmark interest rate that usually gets most of the attention (known as the ‘Bank Rate’ in the UK or the ‘Fed Funds Rate’ in the US). I mean the interest (a.k.a. ‘yield’) offered by a government bond that matures in 10 years’ time.
The reason this 10-year interest rate is so important is that it is the asset off of which virtually everything is - or, at least, should be - priced. It is risk-free in the sense that the investor is guaranteed to earn that yield in the relevant currency over the 10 year period.
Right now government bonds in the US and UK are offering a 10-year return of 4-4.5% per year. This isn’t necessarily hugely attractive but it is in line with or slightly above most assumptions for long-term inflation. So, for the first time in a long time, investors can seemingly protect their wealth over the long term simply by investing in government bonds.
Consequently, in my view, lots of other investments look expensive relative to government bonds. In general, I think the more complicated the investment the more expensive it looks (even after such investments have been walloped over the past 12-18 months). Real estate with lots of borrowing against it is an obvious example, especially if that real estate is low quality and cannot raise rents to work itself out of its higher debt costs. I also think many ‘infrastructure’ investments continue to offer poor value versus government bonds; the extent to which they yield more than government bonds is just not enough to justify the elevated risk. Debt-laden private equity is another example.
It is worth noting that if interest rates were to decline in an orderly manner then the 'more complicated' investments I’ve just identified will likely be the best performers. I can envision scenarios where this occurs but there is no way I would run clients’ money on a bet that this will happen; I would much prefer to hold fundamentally stronger cards.
To be clear, the global stock market also looks expensive relative to government bonds. But there’s arguably a good reason for this: shares offer some inherent inflation protection. This is because good companies can raise their prices. Meanwhile, government bonds lose value when inflation increases (e.g. in 2022).
Here’s what I think will happen in the coming years: government bonds will yield a little less than inflation. I suspect this will be because inflation is a little higher than the market currently expects (in more technical terms: inflation expectations will increase more than government bond yields will decline). If I am correct then government bonds will prove to be a fairly poor investment in the sense that one’s wealth will not keep pace with inflation. In such a scenario, equities should prove to be the winner. This should be especially true of higher quality equities bought at reasonable valuations.
Therefore, I view government bonds not as a good investment per se but as a reasonably good ‘hedge’ for portfolios that should maintain their exposure to equities. This is why we now own a significant proportion of government bonds (having had a 0% allocation at the start of 2022). We also continue to own ‘market neutral’ funds which have performed well despite the increasing interest rates of recent years. The proportion of equities within one's portfolio depends on their specific risk appetite which, in turn, is an outcome of the financial planning process that is unique to the individual, charity or trust.
Indeed, our portfolios are much simpler today than they were in 2022 when we owned cash, USD short-term bonds, gold and other funds that, thankfully, did reasonably well when standard government bonds were performing so poorly.
The view now is that a simpler portfolio will prove the more robust portfolio.
Scott Tindle, CFA is the Founder & Director of Wealth Management at Tindle Wealth Management.
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