Not many would have picked the euro as being the strongest major currency last year but the gamechanger was the announcement of an EU fiscal package which for the first time involves debt mutualisation and the promise of a unified rather than single country fiscal policy in the future. After a decade of being the currency of choice the mighty greenback appears to be losing its lustre, suffering from its loss of ‘carry ‘advantage following the large relative fall in Treasury yields. As a classic ‘risk off’ currency the dollar has suffered as financial markets have become more optimistic about mass immunisations and the better economic prospects for other, more economically cyclical countries this year. Sterling, as always, has been a hostage to the fortunes of Brexit which is hopefully a cloud now finally lifting. In my 15 years at HFMC the one asset class I’ve always warned against forecasting with any confidence at all is the FX market and I see no reason to change my view now!
A Three Pipe Problem
The great bull market in equities and bonds began in 1981 as Charles married Di, Mrs Thatcher was in No.10, Ronald Reagan in the White House, Villa were First Division champions and Chelsea were in the second division, happy days. Soft Cell and Adam and the Ants were heralding in a glorious decade of music and we were watching Brideshead Revisited on TV. For financial markets 1981 marked the arrival of Paul Volcker at the US Fed whose war on inflation was the harbinger of decades of falling interest rates and a boom in financial assets.
For all the economic boom and busts, the bull and bear markets, the ‘it’s different this time’ arguments, two plain truths underpinned equity markets over these decades and many before them.
- Over the very long term equities return 5% + inflation per annum, with the booming 80s and 90s producing double digit returns after the horrors of the 1970s followed by a negative return in the noughties before returning around 5% average real return in the last decade.
- Equity markets reward the optimists who stick with them through thick and thin. Buy and hold works, and while market timing is clever if you get it right, it is a double-edged sword. You want to be in, not out.
Bond markets, hmm, trickier. I’ve always loved bonds, you get your money back, a decent income stream, and with four decades of falling interest rates a very respectable capital gain as a bonus. Going back 100 years Government Bonds have produced an average return of around 1.5% plus inflation but over the last 40 years this has been closer to 3.5% and nearer 4% for corporate bonds. This is very respectable, especially when it has been coupled with much less volatility than the equity market and very few periods of negative returns. The added bonus was that when equity markets fell, the automatic response of Central Banks has been to cut interest rates which boosted bond market returns just when your portfolio needed it. Bonds gave you a decent return, low volatility and portfolio diversification. What’s not to like?
Actually there is something not to like which is the future outlook, with minimal returns from bonds likely in the coming decades and their portfolio diversification benefits markedly curtailed. Bond markets have very long cycles, the 40 years of feast since 1980 were preceded by 40 years of famine with negative returns in the 1950s, 1960s, and especially the inflation ravaged 1970s when bond investors lost even more money than equity investors. The current multi-decade bull market has not yet ended but is at a very tired and fragile stage. It is the strangest of cycles, forever confounding those calling it a bubble and being extended by ‘unprecedented’ events, the 2008 financial crisis and the current pandemic. We are not expecting an imminent ending to the bull market as we expect interest rates to remain anchored near zero for several years hence. What we do expect though is a transition phase between bull and bear cycles in which conventional government bonds will produce minimal returns and crucially no longer much protection in an equity market downturn. This, as the resident of 221b Baker Street used to say, makes portfolio construction a three-pipe problem.
With the current 10 year Gilt yielding just 0.2%, it would need to fall at least a further 1% (i.e. to a substantial negative yield) to offset a 10% fall in the equity market and that is not going to happen. Corporate and High Yield bonds give some pick-up in yield but this is only marginal and brings an element of extra risk to what should to be a ‘safe haven’ asset class through the possibility of bonds defaulting and the likelihood of spreads widening sharply. We thus see bond funds as acting like ‘enhanced cash’ on portfolios, providing liquidity and a marginal return but no longer able to provide the diversification they have historically afforded to portfolios. Should we enter a period of prolonged inflation, not our base case in the next few years but a possibility, then bond markets will fall (yields rise) and the 40 year bull market will finally be over. We remain vigilant.