Mike Coop is the Chief Investment Officer of Morningstar Investment Management Europe, and our Chief Investment Officer for the Waugh McDonald Managed Portfolios
Some investors are losing confidence in classic “60-40“multi asset portfolios invested in bonds and equities, after both performed so poorly last year. You have to go back almost 100 years to see such a bad outcome, so it’s rare. You might think that because it happened, that makes it all the more likely to happen again. But on closer examination, it is more likely that the opposite is true.
Take firstly what the effect of last year’s bond market sell off did: it raised bond yields a lot and left interest rates much higher. So, bonds not only appear much better value, they are also better placed to diversify equity risk. Right now, bonds are less sensitive to future rate rises because as yields rise, their duration reduces. Last year’s inflation shock and spike in inflation rates triggered central banks to aggressively raise rates which in turn is reducing inflationary pressures and causing inflation rates to come down. For the UK and US interest rates are well above central banks inflation targets and they are just above for Europe. While some further rise in rates is possible, large rate rises would make a recession more likely, sowing the seeds for an eventual reduction in rates. So bonds offer both higher returns and less downside.
Bonds are better placed to fulfil their potential as diversifiers for equity risk when you most need it: during a recession. Returns from equities ultimately comes from demand for goods and services all of which fall in a recession. When these falls are large enough they result in dividend cuts, extra raising of capital usually diluting existing shareholders and in some cases bankruptcy if unable to meet liabilities. In severe crisis returns from high yield corporate bonds may also be impacted as companies default. Government bonds are different because in a recession they will pay interest and the full amount of the principal, providing a much higher level of certainty and security than investments related to companies.
Diversifying across asset classes still works but there is more investors can do by going granular and focusing on valuation, compared to sticking with a fixed allocation to global equities and global bonds indices. This was evident in the huge differences in returns between different industry sectors and between different countries in 2022. Taking the US sectors the best performer was +59% for energy and the worst performer -40% for communication services (source Morningstar Direct). So it was possible to generate better outcomes that headline returns for global equities would suggest.
What made 2022 especially unusual was the size of the inflation shock triggered by Putin’s war and the unwinding of a valuation bubble in innovation theme shares and all investments. Losses in stock markets reflected a de-rating, not a drop in corporate earnings and not a recession. The closest comparison I can recall is the 1999-2002 period when a mania for innovation was followed by collapse with interest rates rising and a moderate recession. If we are retracing that path there investors will benefit from holding govt bonds, going granular and being valuation led.
All in all, 2022 is a poor guide to the future of equity-bond based multi asset portfolios, bonds remain an effective diversifier for equity risk and now offer much better returns.