Avoid complacency with investment decisions in uncertain times

If there is a key message it’s that successful asset allocation is always about balancing risk and being nimble.

Someone asked me a few days ago if I had ever known a time when it “was so easy to make money”. That’s an interesting question. Readers of this column will know I become very cautious about complacency and fear it has been creeping in, given the boom in equity markets.

It’s not easy being an asset allocator or investor. We wonder for how long this exuberance can endure, especially as we saw the technology rally tempered earlier this year when the exuberance became contagious.

How have I set up portfolios against this backdrop?

Global equity markets are on a roll with record levels being achieved across major exchanges. At the same time, global bond markets and interest rates are providing little if any return. For asset allocators seeking long-term returns, it’s a dilemma. The situation is compounded by the view that the next move in interest rates will only be upwards; the big question is when.

Let’s consider the impact of rising interest rates on bonds. Remember, the price of a bond moves in the opposite direction to its yield. That’s because a bond’s price reflects the income from its regular interest or coupon payments.

So, in a rising interest rate market, older bonds and those with a maturity or duration of more than 12 months, become less valuable. In fact, they decrease in value because this lower coupon or interest rate has to be taken into account and the face value of the bond therefore trades at a discount.

I have typically allocated to bonds as a defensive play based on wanting to achieve diversification, capital preservation and income. They have also served as a hedge against deflation. Over the past 30 years, interest rates have decreased and with this, bond values have appreciated.

Now, the combination of rising interest rates and low levels of yield or income has put into question the capital preservation argument, as we may not see the negative correlation – bonds performing well when equity markets are stressed – to the same extent. That is why I am underweight bond markets at present.

In contrast, since mid-2020, I have been overweight equity markets across the board. Several months ago, I also pulled back both developed markets and emerging markets to neutral. For the present, the portfolio remains overweight domestic Australian equities, and that’s based on the cyclical nature of our local stock market.

 

Inside the local market it is only in the last month have we moved back to a neutral stance in A-REITs (property trusts). That stance follows on from the extraordinary returns these asset classes have delivered for our portfolios over the past 12 months.

Going back to the dilemma about the low returns from traditional defensive assets: it’s why we see the push to risk-based assets, based on the TINA syndrome (there is no alternative). Understand that these higher equity market returns will also constrain long-term returns.

Many commentators are arguing that long-term returns will be lower and I agree with this view. Last month, I explained how US 10-year treasuries peaked at 15.6 per cent in 1981 and the PE ratio of the S&P 500 index then was 8.5x. Today, treasuries yield 1.6 per cent and the S&P 500’s PE ratio is over 30x.

The conundrum in world investment markets is the “lower for longer” stance the US Federal Reserve (Fed) is taking. Just a few weeks ago, Fed chair Jerome Powell suggested that they’re no closer to hiking rates given the economy is digging out of a deep hole and he thought there was a long way to go. What we have seen since this was signalled to markets by the Fed on June 22 is close to euphoria.

If the Fed tightens too soon, as many have started to speculate, it risks a negative impact on both economic growth and asset prices. The other idea is to let inflation run and see risk-based assets enter a bubble. Yet that will have a negative effect on growth and asset prices when that bubble bursts.

I would not want to be a central banker at the moment. They face a dilemma. Government stimulus to the extent we have experienced it over the past 15 months has certainly politicised the positions of central banks around the world.

Global debt levels are now well in excess of $US200 trillion ($268 trillion). Even factoring in growth, if governments do not increase taxation to tackle this issue (and I am not a proponent of that strategy), then moderate levels of inflation should not be seen as a negative. Inflating away the debt is an alternative.

So back to asset allocation – including property. In the end, it comes back to earnings and looking at these earnings as a support for what you invest in.

None of us have lived through a pandemic before and there are plenty of rear-vision drivers on the investment road. The reality is no one knows where all this is headed. Having seen strong returns in risk-based assets over the past year we have now taken a more prudent stance, except for domestic equities.

If there is a key message it’s that successful asset allocation is always about balancing risk and being nimble. It’s about expecting the unexpected and potentially being prepared to jump in a different direction than originally anticipated. Whatever investors do, they should never be complacent.

Will Hamilton is the managing partner of Hamilton Wealth Partners.

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