Simon Edelsten discusses how charities can benefit from an unconstrained global equity portfolio, particularly in a period where borrowing costs in some countries are negative.

Over the last couple of years, many central banks have cut interest rates aggressively; borrowing costs in Switzerland and Sweden are now negative. At times, this has dragged bond yields in some of the world’s largest economies, such as Germany and Japan, to negative levels.

In theory, these aggressively low interest rates should encourage businesses to invest. But in practice they don’t seem to be having much effect. What they are doing, however, is forcing savers to take more risk if they want a return. And while there has never been a period where interest rates have been negative in so many regions, financial history can still give us some useful guidance as to what type of investment strategy might be suited to these unprecedented conditions.

Don’t fight the Fed

For decades, “Don’t fight the Fed” has been an adage among investors. At the moment, however, the more important rule is not to fight the European Central Bank (ECB) and the Bank of England and the Bank of Japan (BoJ). Their quantitative easing (QE) is seen by some as a logical – even welcome – progression from the large-scale stimulus packages introduced after the 2008 global financial crisis. These policies, however, do not seem to have stimulated any great improvement in the economy. Nor have they kept deflation from the door. But they are keeping rates low.

These unusual economic conditions are making investors unwilling to put too many of their eggs in one basket. However, valuations for some major asset classes make them unappealing. Furthermore, many multi-asset funds have performed rather poorly over the last couple of years, offering a reminder that there is never a case for diversifying into an asset whose investment characteristics are poor.

Unattractive bonds

Traditional government bonds seem pretty unattractive, particularly those whose yields are negative. Over the next couple of years, interest rates in the US may start to rise as the economy continues to expand and capacity tightens. There is already evidence that wages are increasing. This may, in a couple of years or so, give savers a more attractive opportunity to buy US Treasuries. But not yet. Similarly, most index-linked bonds have risen to levels where they may offer, as Warren Buffett put it, a “return-free risk”. Index-linked gilts protect your capital from inflation. But that insurance against inflation is prohibitively expensive.

Golden opportunity?

Some multi-asset funds diversify into gold. The barbarous relic was rather a good investment over the banking crisis and shows a low correlation with those assets that do better when investors are in ‘risk on’ mood. The case for gold is that it would hold its value were confidence in paper currencies to be eroded, and a period of massive QE increases that possibility. That said, the price of gold has fallen from $1,700 to $1,300 over the last five years – so getting your timing right matters. Unlike most financial assets, gold pays no dividends, so deciding what its price should be depends entirely on your view of what a doomsayer might pay for your gold at some point in the future when you become more cheerful.

Solid property

Property’s characteristics are very attractive for the long-term investor. It produces a steady flow of rental income (for as long as one can find tenants) and has a history of being able to adapt to inflation.

There is also this familiar argument: “Buy land: they’re not making any more” (especially in prime locations). The main drawbacks are that direct investment in property involves a lot of admin and assets typically take a long time to buy or sell, so are illiquid. Real estate investment trusts (REITs) offer a more liquid way to invest in property. Yet despite the beliefs of some London residents, property cannot outperform the economy forever – rents can only consume a certain share of national income and this share tends to revert to the mean over the long term. Normally, landlords’ share of the economy falls during periods of inflation because rents tend to lag price rises. Companies with the power to raise prices rather more quickly tend to cope with inflationary environments rather better.

An unconstrained global equity fund can invest in any of the above asset classes. If we want property, we buy REITs. If we want exposure to gold, we could buy gold miners. If we want bonds, some financial shares follow different shifts in the yield curve.

How diversified can an all-equity, long-only fund really be?

On the face of it, an unhedged equity fund may not appear particularly diversified. Remember that assets which had once been considered uncorrelated have actually shown a worrying tendency to fall in tandem when diversification is most needed: commodities and equities, for example, both fell in 2008.

Yet global equities actually offer a diverse range of investment opportunities. World markets rarely rise and fall in lockstep, particularly not when currencies are taken into consideration. For example, Japanese companies have very little correlation with internet stocks in the US. Neither group has much correlation with European bank shares.

Remember too that the great global bear markets of the past – when share prices worldwide fell all at once – have generally had one of two characteristics: either economies were riddled with debt (as in 1980 and 2008) or the valuation of equities had become overstretched (1987 and 2000). Currently, governments are indebted but companies tend to be flush with cash – perhaps the credit risk of a diversified portfolio of quality companies is lower than lending money to sovereign borrowers?

Valuations of equities are certainly higher than they were five years ago. On valuation grounds, we took a more cautious view 18 months ago. Since then, however, the cashflows of many of our investments have increased enough for us to regard valuations of a good range of investments to be attractive.

What might change?

We may be approaching the limits of what QE and negative interest rates can do. In some regions, they have proved feeble in restoring economic growth. Deflation still seems to haunt the ageing European economy, just as it has hung over Japanese investors for 25 years. Looking back to the great US deflation of the 1930s, Keynes identified that deflation had left real interest rates high even though nominal rates seemed modest. The radical insight that proceeded from this was that ‘prudent’ housekeeping of the economy was inappropriate. The orthodoxy among central bankers of that era was a belief in balanced budgets. Keynes’ radical insight was that governments should spend when others are over-cautious. This lesson seems to have been lost on Europe’s central bankers – no wonder we face hoarding of savings and an absence of animal spirits.

If there is any move in a more Keynesian direction and away from austerity, it may provoke a recovery in demand and a modest increase in inflation. Historically, when interest rates have risen to control inflation it has been sensible to be cautious about equities. However, between 1970 and 2008 equities yielded less than bonds and thus offered no protection when rates rose. The opposite is the case today. Indeed the yield gap is currently the widest it has been since the 1970s. That said, in unprecedented economic conditions, eggs should be spread across many baskets.

Simon Edelsten is manager of the Artemis Global Select Fund.

Charity Finance wishes to thank Artemis for its support with this article