Editor’s note: This article contains information only. It is not intended as general or personal advice. Your Money recommends seeking professional advice specific to your personal circumstances.
The outlook for risk is shaky. On a tear since hitting lows on Christmas Eve 2018, equities have rallied in rude fashion fuelled by an easing in fears which had gripped investors during the last quarter of 2018, including trade negotiations between the US and China, global growth worries and a hiking US Federal Reserve.
However, while stocks were getting their groove back, the bond market has remained unconvinced.
The two asset classes have been telling very different stories. On the one hand equities were playing down the macro fears, while on the other hand US government bond yields have been falling, indicating real fears around the outlook for the US economy.
Now, it’s worth pointing out that mixed signals from equities and bonds is not new. There have been plenty of occasions where bond yields have been falling while equities rally.
The problem is it’s a dynamic that can’t continue and more often then not it’s the bond market which has been proven correct.
A lot is being made of the inverted bond yield in US treasuries.
It was a feature of Q4 as markets started to price in the real prospect of a US recession. What is sometimes missed in the observation of an inverted yield – and the suggestion that it is a good indication of a looming recession – is that it’s not so much the inversion that matters but the length of time the yield curve remains inverted.
And it’s not just US bond yields falling. Japan’s benchmark has dropped to its lowest since November 2016. Germany’s 10-year Bund yield had drifted into negative territory for the first time in three years. And here at home, the yield on the 10 -year Australian government bond has hit a record low as well.
The catalyst for the latest fall in yields is the increasingly dovish commentary from central banks (most notably from the US Fed, which has slashed the outlook for raising rates to just one more by 2021) amid a slowing global growth picture.
The latest blow to the fading optimism for global growth being the contraction in German manufacturing.
Set against that sort of global backdrop, what should investors be thinking?
Firstly, developed equity market total returns are around 15 per cent since the December lows. That is extremely unlikely to be maintained.
Investors too often get caught out extrapolating past performance into future performance.
Therefore, asset allocation is critical.
Australians have historically had a love affair with equities and real property and over the last couple of decades that has proven to be a beneficial position.
That weighting, though, has come at the expense of other asset classes, namely fixed income (government and corporate bonds, hybrids etc).
However, in an environment of slowing global economic and earnings growth, asset allocation can help provide downside protection commensurate with an individual’s risk tolerance and return expectations.
According to investment manager Vanguard, 88 per cent of your experience (the volatility you encounter and the returns you earn) as an investor can be traced back to asset allocation.
The aim of investing is to make money. I’ve yet to meet anyone who’s investment strategy includes losses.
However, the reality is that equities are a risky asset, which means the chance of losses is high in comparative terms.
In an environment of heightened volatility asset allocation can help smooth out the drops and keep your total return target in play.