26May 2016

Mike Brooks

Head Of Multi-Asset Growth Strategies

Time to diversify

In the eyes of many investors, bonds and equities enjoy a domestic relationship much like the man and woman in a traditional Alpine weather house. The female figure comes out with a sunshade when it’s dry, while the man comes out with a macintosh when it looks set to rain – and they are never out of the house at the same time.

It’s often assumed that, in the same way, stock and bond values will not move together. Rises in one of the two asset classes have compensated for falls in the other, and the overall performance of portfolios based on a simple blend of equities and publicly issued debt has been strong. On this rock of certainty many portfolios have been built.

But on closer inspection this rock has cracks in it. There have only been two periods since the Second World War when five-year rolling returns for US stocks and US government bonds have shown a negative correlation: 1955 to 1965 and, more recently, over the last 15 years or so. In other words, the anomaly is not when stocks and bonds move in the same direction; the anomaly is when they don’t. This relationship is embedded in the “Fed model” of markets – if the yield that an investor can earn on bonds goes down, agnostic investors should also be willing to accept lower yields on equities.

If the sunwoman and the rainman do again start to come in and out together more frequently, investors will be in for a bumpier ride than they have been used to – and there are a few reasons to be concerned that this may prove to be the case over the years ahead.

What can investors do, if stocks and bonds start to behave in the same way as we are increasingly anticipating? The solution is to find investable assets that do behave differently. This is not uncharted, dangerous territory. Portfolios based simply on stocks and bonds are no longer the norm. These days portfolios can be bolstered with alpha strategies, property and infrastructure, to name but three extra asset classes.

Some of these asset classes can offer a low correlation with stocks or bonds, while still providing the growth that investors need. Infrastructure investments benefit from cash-flow generating assets – such as wind and solar panel farms – rather than the vagaries of the stock market. The burgeoning market in catastrophe bonds goes one step further: defaults have nothing to do with the economic forces that plunge bondholders into financial trouble, and everything to do with the damage caused by extreme natural events.  

While we have always believed that diversification is a key to generating sustainable long-term growth, over the last 12 months we have been increasingly allocating to non-traditional investments. This reflects our concern about the increasing downside risks to our central view - equities have had a strong run since the depth of the Global Financial Crisis leaving them increasingly sensitive to downside risk. The economic backdrop - and government and central bank action to address it – has also contributed to historically low bond yields. This means that, not only do traditional bonds offer little in the way of future return, but also that they are likely to offer less diversification benefit alongside equity - a number of our economic scenarios would likely see both equity and bond markets falling together. 

It is, however, important to also remember that diversification should never be undertaken purely for diversification’s sake. Simply buying an asset blindly is never a good idea. We find many attractive opportunities within alternatives and their inclusion in portfolios is therefore warranted on merit as well as for diversification reasons.

Ultimately, multi-asset investors no longer have a single couple living in their weather house.  With the sunwoman and rainman joined by their weatherfamily and weatherfriends, there is now more chance to see someone standing outside the door, smiling down on the owner of the house.

It’s time prepare for the future – it is time to diversify.

Mike Brooks,  Head Of Multi-Asset Growth Strategies

Alternatives

Investment Idea

Corporate Bonds

Investment Idea

Equity diversification

Investment Idea