The future looks even more uncertain than usual. Normally uncertainty translates into lower asset prices. But not this time. And with the prices of all assets buoyed by central bank support, we fear a traditional “diversified” portfolio won’t work in the future.
In particular, we believe that conventional bonds will provide neither acceptable returns in good times, nor much protection in a downturn.
This will be a shocking contrast to the last 40 years. Interest and inflation rates have been falling steadily since 1981. The result has been that an investor combining equities and bonds has received excellent returns from both. Better still, when the equities fell, the automatic response of central banks has been to cut interest rates. This conveniently boosted bond prices just when the equities were suffering. The result was that the risk-adjusted returns – the returns adjusted for sleepless nights – from a traditional portfolio containing both assets were particularly attractive.
What drives the price of a bond up is when the yield – the interest rate paid compared to the bond price – goes down. But yields are already about as low as they have ever been. At such low levels, is there much room for bonds to be as protective as they once were?
In a traditional balanced portfolio (combining 40% bonds with 60% equities), the yield on 10-year UK government bonds would have to fall to -1.2% to protect against a mere 10% fall in equities. That requires investors to be willing to lock in a guaranteed, and significant, negative annual return.
And these are yields on conventional bonds, so represent the returns before taking inflation into account. Inflation is unusually depressed, but positive even now. If, as we expect, the scale and scope of government spending marks the beginning of a new more inflationary era, then these negative nominal returns could be even less appetising. Deducting the average long-term inflation rate since 1950 would mean accepting a real return of -6.5% in the UK. We can’t see investors accepting this. This means bonds can’t protect an equity portfolio.
So, if conventional assets and traditional diversified portfolios cannot provide the protection required to keep portfolios safe in an uncertain world, what can? We think that this is the key question that long-term charity investors should be asking themselves and their investment managers.
Hermione Davies is an investment director at Ruffer
Ruffer LLP is a limited liability partnership, registered in England with registered number OC305288 authorised and regulated by the Financial Conduct Authority. The information contained in this article does not constitute investment advice or research and should not be used as the basis of any investment decision.