We’ve taken your most pressing questions to our in-house investment professionals to answer them.
Question: Could the current low bond yields justify the high equity prices? Is there further room for even higher equity prices over the next 1 to 3 years?
Of course, they may be justified—and may even go higher—however we’d need to distinguish between cyclical and structural developments. That is, the long-run equity value discount rate really depends on whether borrowing costs will stay low permanently, due to some structural development, or likely to revert higher as conditions return to normal. This can be broadly captured in three scenarios.
1. In the ‘permanently low rates’ scenario, higher equity prices could be validated. Corporates will enjoy cheaper funding, default risk may remain lower than historical norms, and a transfer of wealth could see investors move from low-yielding bonds or cash into higher-yielding stocks.
2. In the ‘mean reversion’ scenario, the long-run relationship between unemployment and inflation will eventually stabilise, with rates nudging higher over time. As a result, profit margins will also likely normalise, sending equity multiples back to historical norms.
3. In the ‘inflation shock’ scenario, we may see the extraordinary levels of monetary stimulus create an unexpected rise in the cost of living. This would cause central banks to increase interest rates, likely suddenly, with both bonds and equities hurt at the same time.
While we must be open to the full range of possibilities, the probable outcome is that conditions eventually normalise. On this point, we think its dangerous behaviour to extrapolate recent trends into forecasts, so are generally sceptical of those predicting low rates forever. As Mark Twain supposedly said, “History doesn’t repeat itself, but it often rhymes.”
Question: Will diversification strategies continue to work given the unprecedented markets today?
At Morningstar Investment Management, we take diversification seriously. However, we’re generally quite sceptical of those who rely on historical correlation assumptions and prefer to instead look at it under the lens of fundamental diversification. That means we’re looking for an asset allocation that stands up to different risk drivers, not just co-movement.
As a simple example, it can be dangerous to buy equity in a company and then buy a bond from the same company, thinking you’ve got stock/bond diversification. The co-movement may look like diversification, but this won’t be helpful when it matters (if the company goes bust). The same can be said for asset classes, where an investor should think carefully about the underlying risk drivers of their asset choices. This has never been more important than it is today.
This question also highlights the important balance between conviction and overdiversification. Some of the greatest asset managers—whether equity-only or multi-asset—use concentration effectively. They balance out downside risks, to ensure the probability of permanent loss is small, but otherwise hold their highest conviction assets. At the other end, overdiversification can sometimes be a poor choice, as additional trading costs eat away at returns without any commensurate benefits.
Question: You’ve held high cash levels for some time. Why do you think it’s appropriate to hold elevated cash levels right now?
First, to establish a few facts. We think more cautious investors, or those with a limited investment timeframe, can benefit by holding healthy cash levels at present. For adventurous investors with a longer timeframe, the role of cash is still valid, but the sizing will often look quite different to those of a cautious investor (typically smaller).
Turning to our thesis, we are reminded of Warren Buffett’s quote, “holding cash is uncomfortable, but not as uncomfortable as doing something stupid”. It is counter-cyclical behaviour. To put a finer point on it—with bond market prices at record highs (yields at or near record lows) and equity market prices also near record highs, we believe it is prudent to protect capital. We think about this holistically, reducing the risk of a permanent loss by: a) favouring cheaper assets with less room to fall, b) offsetting risk via uncorrelated assets, c) using cash as a store of certainty, and d) monitoring the stewardship of all underlying investmentvehicles held.
But cash is also a form of offence, offering liquid ammunition that can be deployed as opportunities present themselves. Say, for example, that inflation unexpectedly jumps, causing central banks to raise rates quickly—a scenario in which stocks and bonds would likely fall together. Those that hold cash are in a position of power. This is just one scenario where cash would help an investor, but it will also work in several other scenarios that involve interest rate normalisation, a liquidity crisis, or a sudden market panic.
Importantly, we must disclaim that holding cash is not an effective long-term wealth strategy. It tends to earn less than inflation, which erodes your net worth. So, yes, we’ll use it to improve investor outcomes, but wouldn’t recommend it as a long-term wealth creation or preservation plan.
Question: Is gold something you consider in portfolios? When interest rates are negative, doesn’t this eradicate any disadvantages against cash or bonds?
We currently don’t invest in gold in our multi-asset portfolios, apart from the portfolios we offer in India. In general, gold doesn’t offer any cashflows to value (or compound), thus we’d expect gold not to generate a real return that is significantly above 0% in the long run. It is too often traded speculatively, where the future price is dependent on what the next buyer thinks it’s worth. To be clear, a zero percent real return might not be far off some fixed-income markets in terms of current yields, but it doesn’t make it an attractive investment (we also note there is not a carry premium associated with investing in gold).
To acknowledge the role it can play, gold does have some risk-hedging properties and may outperform in a risk-off environment. However, our research indicates that long-duration bonds (especially highly-rated government bonds from developed market nations) are generally a better hedge than gold in a risk-off environment. In general, gold is likely to do best in a stagflation or dollar crisis-type scenario, although these are low probability events.
Therefore, while gold can be debated as part of a risk management or portfolio construction exercise, it is highly unlikely we’d have long-run allocations to gold.