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Will Asset Class returns go their separate ways?

Dispersion of asset class returns-train track

Investment returns since the Global Financial Crisis of 2008 have been exceptionally positive. Investors have been handsomely rewarded and enjoyed prolonged periods of low volatility.  Furthermore, there has been sustained, higher correlation of asset class returns, meaning every asset class has continued its trajectory. What were the causes of this scenario, its implications for investors and, importantly, is the tide changing?

What has caused this asset class return scenario?

This benign investment climate stems from the central bankers’ bid to stimulate global economies after the Credit Crunch. Firstly we saw – and continue to see – interest rates reduced to record lows. This has been combined by the central banks with purchasing of government bonds, and in some cases corporate bonds, through quantitative easing (QE). The effect of governments driving up the price of bonds through a combination of rate cuts and bond purchases has led to abnormal returns from the sector. In turn, low-interest rates have made fixed interest a less attractive sector for new money to consider and that has forced investors to look up the risk spectrum at equities. As more and more investors turn to the stock market, short supply and strong demand have boosted returns from share ownership. Finally, lower interest rates have spurred property investors to seize the opportunity of cheap money to buy, which has been positive for returns in that sector.

Will Asset Class returns go their separate ways?

What are the implications?

As a result of these effects, we have experienced a sustained period in which nearly every asset class rose together. This is demonstrated in the chart above, with the possible exception of Emerging Markets which struggled in April 2015. Clearly, this is a great result for investors, especially those willing to ride out shorts bouts of volatility along the way. However, what it suggests is that the stock market’s rise has been less about company fundamentals and more about market momentum. The growth we have seen in ETF’s and passive funds have enhanced this trend because investors simply buy the entire market. Within the world of equities, this means companies with a potentially poor outlook continue to be bought. But possibly more worryingly is the implication within fixed interest exposure, where the most indebted companies continue to receive more and more backing from rising sales of trackers.

Is the tide beginning to change?

The QE tap was turned off in the US at the end of 2014, nearly three years ago, while it remains firmly turned on in the UK, Europe and Japan. However, it is not all about QE. We have started to see a rate rise cycle begin in the US, which the Federal Reserve seems intent on pursuing. Also, until weaker inflation numbers were released a fortnight ago there were mutters coming from the Bank of England and also from the ECB, questioning when rates might need to rise. After such a sustained period of ultra-loose monetary policy and rock bottom rates, this would no doubt have a market impact.

It is after this kind of shift in the market environment, with rising rates, that we feel future performance will be based more on company fundamentals. Poor companies are more likely to be punished especially if they have failed to modernise themselves in the years of easy money. As a result, the high correlation between asset classes which we have noted above should begin to reduce and we will experience a more obvious divergence in asset class returns. While some produce positive returns, others may not.

The benefits of diversification have become harder to evidence during this extraordinarily positive period of returns, it has however reasserted itself through some short and sharp negative periods along the way. We strongly believe that looking to the future, diversification will be as important as ever. This is why we continually analyse our portfolios to ensure clients retain a diversified portfolio, with a good spread of exposure at the headline asset class level and a good spread between ‘sub-asset classes’. The overall goal is to provide a consistent investment journey, ensuring clients stay within the volatility band they are most comfortable with while capturing the appropriate investment returns through the numerous market environments and scenarios their investments will experience.



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