2022 was a volatile year for investors in all asset classes. A major reason for this was the end of a period of extremely loose monetary policy, which has its roots in the response to the Global Financial Crisis of 2008.
The path of interest rate increases, once started, was aggressive, with UK rates increasing from 0.1% to a current rate of 5.25% and those in the US from 0.25% to 5.50%. This caused equity investors to reprice the value of future earnings and fixed income investors to adjust the yields of bond holdings to mirror rate increases. Some banks have offered deposit rates at the same level as their central bank for one-year terms in order to attract deposits. After the volatility of last year, some may be asking:
why take risk in a world where a known 5% return is achievable?
After 15 years of low interest rates, this is undoubtedly attractive and, where appropriate, we hold short-term government debt in portfolios to enhance the yield we receive on cash. This may be via a liquidity or money market fund or by holding Gilts, Treasuries or Bunds directly. However, these rates are not expected to persist, with the Federal Reserve (Fed) likely to begin cutting interest rates next year and may be joined by other central banks if a recession materialises.
Our view has been that the market was premature in expecting rate cuts this year given the inflationary and labour market backdrop, but the Fed is wary of choking all economic growth and would prefer to loosen when conditions allow.
Therefore, taking advantage of short-term rates faces reinvestment risk.
That is, the risk that investing the proceeds of any bond maturity or term deposit will be at a lower rate.
A singular focus on yields also ignores the potential for capital appreciation by equities. After a poor 2022, where rising bond yields caused investors to almost universally downgrade the value of future earnings, 2023 has seen a re-appraisal of the potential earnings power of the global corporate. This is primarily because economic conditions appear positive enough to have avoided a coordinated global recession and each quarter corporate earnings are better than feared.
This has resulted in equity returns being more dispersed than we have become accustomed to in this 15 year period of monetary repression. However, it also gives active managers the opportunity to generate returns. While we do not predict an absolute value for market return, we do believe that, structurally, nothing has changed and that economic growth will continue to be positive over the medium to long term, with equities displaying the best correlation to overall economic growth of the asset classes we invest in.
We therefore continue to advocate holding equities in a portfolio where appropriate for an individual’s risk tolerance, in order to have the potential to generate a positive real (inflation-adjusted) return over the medium to long term.
As with much of life, we believe that balance is crucial. Our portfolios are constructed with diversification across asset classes in order to smooth returns over the long term. We primarily view sovereign fixed income as a protective asset class and believe that it will resume its role in protecting returns when recessionary fears rise.
Corporate bonds give us the opportunity to earn a higher yield than their sovereign equivalent, but we would caution that spreads (the difference between the corporate bond yield and its equivalent sovereign) are low at present, which lessens their attractiveness on a risk adjusted basis.
Where a short-term liability exists, we now have the ability to earn a yield without taking undue risk and, for all other investing, we would paraphrase the old investment adage: it’s about time invested in the markets. We are confident that over a multi-year period the returns earned by taking market risk outweigh the seeming attractiveness of a certain short-term yield.
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