How will the recovery influence risk and returns?
As the macro risks associated with COVID-19 have loomed over global markets and economies for almost a year now, changing expectations of the shape and strength of the recovery will be important in influencing returns and volatility for 2021. We recently sat down with Mark Burgess, Chairman of the Advisory Board at Jamieson Coote Bonds to discuss this and other important issues on investors' minds.
Navigating the economic recovery
This recovery is unique as we’ve seen one of the most dramatic interventions in markets in history, to the credit of central banks and governments who took immediate action last year and we are now beginning the see the consequences of that. Will it take traction in the economy? How will the virus develop? These are critical issues which are raising serious question marks about the style and nature of the recovery. Financial markets are looking through this – at some of the beneficial aspects of low rates and at the rising liquidity aspect of central bank intervention. The economic environment is rather unclear, relative to financial markets, which are taking a forward looking view.
Inflation risks on the rise
I'm always reminded of what I believe is the right approach to risk and look to a range of scenarios, such as economic growth. Inflation should be one of those scenarios. How does inflation play out? Is it a rising risk? We're likely to get an uptick in inflation as the year-on-year comparisons turn positive. There are a couple of factors that have helped keep inflation low in the past, such as globalisation, that appear to be changing and therefore the ability to keep inflation at low levels is changing at the margin. On the flip side, we have very slack labour markets, we have an output gap that's quite wide, and at these low interest rates, capacity can be added quite quickly across the world. With this in mind, my expectation is that perhaps inflation will uptick but we're unlikely to get the kind of embedded or serious inflation that we saw say in the 1970s. Competition caused by excess investment as a result of low interest rates could cause deflation in parts of an investor's portfolio, and the inflation-deflation combination should be assessed across the assets that go into a well-diversified portfolio. Watch the video to hear more.
Constructing fixed income allocations - the risk of chasing yield
Yields are going to be low generally and the most important risk is not to chase yield for yield sake. If you're chasing yield with risk attached to it, those risks will be lurking in the background more over the next two to three years than they have in the past. As bond yields are marginally moving back up, they're getting ready to be a defensive asset again. Markets are experiencing this combination where yield is becoming available in some places and in other places there's certainly a lot of competition for yield. Investors should be cautious as risk attached to yield is one of the most important things to watch out for. We've long advocated this; one example is separating corporate credit from high grade sovereign bonds. High grade government bonds provide safety, while corporate credit will have other risk and return characteristics. Most importantly, as we come out of the COVID-19 environment, we'll find out which corporates are safe and which are in good shape as we see that part of the cycle play out.
"The most important risk is not to chase yield for yield sake."
The important role of high grade government bonds in diversifying some of the unknown risks that remain
High grade government bonds were defensive during the downturn, playing the important diversifying role that they have always played in portfolios. As government bonds edge slightly higher again, they will provide that defensive characteristic and diversification within a portfolio. We believe they will always be a good asset to hold. Australian investors haven't held a large position in government bonds historically, and a key lesson from the events of last year proved the diversification characteristics of the asset, at a time where diversification was difficult to find. There are a couple of other places to find diversification, but high grade government bonds are certainly one component of that. Watch the video to hear more.
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In times of uncertainty, adding high-grade bonds to your portfolio can provide much-needed stability, liquidity and diversification. Find out more here