Speaking at the Financial Services Council’s inaugural Investment Summit recently, Dr Arndt, said the Future Fund has adjusted its approach to portfolio construction by throwing out conventional wisdom relating to constructing a portfolio.
One significant change that made many sit up and take note, is that the fund has erased nearly all of its exposure to government bonds. As Dr Arndt said, “there’s not much defensiveness left in those securities”.
His view is that while it’s important to have a defensive asset mix in a portfolio, with interest rates at record lows, there’s very little defensiveness to be had in this asset class and investors need to look elsewhere.
He is not alone in this observation. Indeed, during the equity downdraft in March of this year, it was the case that German and Japanese bonds also proved to have poor diversifying characteristics. US Treasuries too provided poor diversification during the recent episodic equity weakness in the lead-up to the US presidential election.
These examples effectively call into question the diversifying qualities of nominal government bonds in all multi-asset portfolios. And it may be that investors need to seek alternatives as investment options, as the diversifying properties of government bonds decrease as yields approach new lows.
Investors may wish to shade traditional bond exposures and contemplate incremental exposures to “defensive alternatives”.
The impetus for a rethink on the composition of multi-asset portfolios is emphasised by an ongoing shift to fiscal policy as the primary macro support tool and an attendant increase in the supply of government bonds. This comes at a time when more “innovative” approaches to monetary policy, combined with structural forces, perhaps herald the end of the deflationary trends of the past 30 years or so.
The fall of the Berlin Wall in 1989, followed by a dramatic increase in prominence of key emerging markets (particularly China), at a time when baby boomer participation in the workforce was at its highest, and female participation was secularly increasing, resulted in a rolling global labour supply shock. The result was a decline in wage growth and a structural deflationary trend on a global scale.
The waning of those influences in recent times, combined with the supply disruptions wrought by the COVID-19 pandemic, abetted by deglobalisation and re-regulation, and central banks possessing greater tolerance of inflation, may well mark the dividing line between the deflationary forces of the past 30 to 40 years and resurgent inflation.
So, what are the alternatives to nominal government bonds in an investment portfolio?
For investors concerned about the prospect of future inflation, inflation-linked bonds are an obvious alternative.
Equally, “absolute return” or “unconstrained” bond funds – which are not benchmark constrained to a particular duration level and generally have a broader investable universe – are another viable alternative. In this way, they are not as vulnerable to increases in bond yields but still possess less volatile return streams that investors associate with bond portfolios. Some of these portfolios, however, can sometimes have exposures to lower-rated credits that can negatively affect performance during “risk-off” periods, which can have the effect of mitigating their diversification benefits.
Dr Arndt’s advice? He suggests a sectoral equity allocation to consumer staples could be an alternative.
And despite recently hitting price highs, gold is another option.
Investors have always appreciated gold’s “safe haven” or defensive attributes, but in contrast to nominal bonds, gold is also a good hedge against inflation. Even in the event that bond yields stay low, the opportunity cost of holding gold remains diminished, increasing its attraction.
Further, gold is not adversely influenced by the complexities and attendant challenges for central banks that attach to “exit strategies” from the current extraordinarily accommodating global monetary policy settings. And gold provides safety in the event of any escalation of geopolitical concerns, of which there is no shortage.
The vicissitudes of investment markets have been a particular challenge in 2020. Dr Arndt’s comments are a timely reminder that those challenges are ongoing.
Stephen Miller, investment strategist, GSFM