A time to reset back to ‘normal’

For the past 10 years investors have become accustomed to double digit returns from equities and low market volatility. As interest rates normalise we are heading into a different market environment characterised by higher volatility and greater dispersion in returns between stocks. For some investors the last 10 years’ market environment is all they have known, while for others what markets were like prior the global financial crisis of 2008 is a distant memory.

We would argue that the past 10 years which was characterised by record low interest rates and ample liquidity, was not a normal market environment. In fact, it was an anomaly resulting from extreme unconventional monetary policy settings aimed at avoiding a deep recession or a global depression following the breakdown in financial systems in 2008. As central banks sailed down the path of quantitative easing (QE), at the back of their minds they were scratching their heads as to what will be their exit strategy from QE. Roll forward to today and inflation has given central banks their exit strategy, with key central banks raising interest rates and tapering their respective QE programs in order to stem demand and dampen inflation.

The move towards higher interest rates is a rest for the global economy and markets. Debt has become more expensive and companies which existed due to readily available cheap debt are disappearing or at a minimum being repriced aggressively. In this environment we are likely to see the strong get stronger and an increase in merger and acquisition activity as cashed up companies look for opportunities to grow their market share by acquiring companies with weaker balance sheets.

From a portfolio perspective, in this period of transition the traditional 60/40 portfolio has suffered as both equities and bonds have repriced as interest rates and bond yields have risen. So, does this mean that the traditional ‘balanced’ portfolio is dead? Our view is that the transition to higher interest rates will be painful however that as we reset to a more ‘normal’ market environment a ‘balanced’ style portfolio made up of equities, bonds and other assets such as alternatives will come back into vogue. In recent years a strategy of simply having an overweight to equities has been a winning strategy. However, we expect greater market volatility will make investing in equities less clear-cut and investors will need to be more discerning as to the companies they hold. Furthermore, the ‘unsexy’ world of bonds will become more interesting as bond yields rise and the relative attractiveness of bonds to equities increases.

We believe that we are heading back to markets of old where investors should expect single digit equity returns over the long term and higher levels of market volatility. In terms of total portfolio returns, we expect that diversification will become more critical and bonds will play a greater role in contributing to portfolio returns in the future.

Source: Lonsec

Reproduced with the permission of Lonsesc. This article by LUKASZ DE POURBAIX was originally published at https://www.lonsec.com.au/2022/11/02/a-time-to-reset-back-to-normal/

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