You probably didn’t think it was easy at the time, but looking back over the past 25 years or so investing has not been complicated. A simple two asset portfolio (60% shares, 40% bonds) has provided a high-single-digit growth rate with moderate volatility. It’s been the financial adviser’s friend and a sleep-at-night strategy for DIY investors. That golden age is over.
The reason the 60/40 approach worked was that shares and bonds behaved differently. In the jargon, they were uncorrelated. One went up, the other went down. For a few reasons that might no longer be the case. And if shares and bonds start to move more in lockstep, investors will need to look further afield to find the soothing portfolio mix they have enjoyed in recent years.
Donald Trump watches the bond market like a hawk. He’s a property man. And for him the cost of borrowing is everything. He understands that there’s a watershed point for bond yields above which bad things start to happen. It’s why he abruptly changed tack a week after ‘liberation day’. And what’s true for the President is also the case for stock market investors. Yields above 5% are bad news for bonds (yields and price move in the opposite direction) but they are bad news for shares too.
There is a handful of reasons why bond yields have returned to pre-financial crisis levels on both sides of the Atlantic. They are not all bad. For example, the easing of Germany’s debt brake to fund defence and infrastructure spending implies faster growth in an economy that has tended to spend too little rather than too much. But most are more concerning. All are responses to heightened uncertainty.
Last week’s ‘big, beautiful bill’ – Liz Truss’s mini budget on steroids – is the latest reason to worry about the risks of lending to Uncle Sam. But this is not a new concern. Even before the budget squeaked through Congress, the US government had borrowed $2trn (around 7% of GDP) in a year. It’s no surprise that Moody’s became the last of the big three ratings agencies to take away Washington’s triple-A stamp of approval two weeks ago.
Here in Britain, bond investors also fret about the mismatch between what the government wants to spend and is able to raise from taxpayers. But that’s not the only reason yields on gilts are climbing (to 5.5% for the 30-year bond). Last week’s jump in inflation to 3.5% prompted investors to demand a higher return on their bonds to compensate for the erosion of the real value of their income and capital. In Japan, too, the home of deflation for 40 years, prices are rising at a similar pace.
This combination of policy uncertainty and inflation is the principal reason why bond yields are rising even as interest rates are flat or expected to modestly fall. The longer a bond has until it is due to be repaid, the more compensation investors are demanding. This is why the long bonds that are a staple of many pension funds are feeling the pinch. The effect is made worse by the fact that those same pension funds are buying fewer of these long-dated bonds as final salary pension schemes wind down in favour of defined contribution plans. Governments issuing more bonds and traditional buyers (including central banks) buying fewer of them. Another reason to expect yields to rise and prices to fall further.
So, that’s why bond yields are heading into the danger zone. How does this map across into the stock markets on which most of us tend to focus? Well, it’s a concern for a couple of reasons.
The first is that history shows that the higher bond yields go the more correlated the prices of bonds and shares become. During the post-financial-crisis era of zero-interest-rate policy and quantitative easing, low bond yields went hand in hand with see-saw movements in the two main asset classes. They balanced each other out. That was not the case between the 1960s and 1990s when rising yields led to lower prices for both bonds and shares and vice versa. With yields back above 5%, we are back in that environment again.
Second, the more correlated bonds are with shares, the more sensitive investors are to the relative competitiveness of the two assets. If you can get 5% from an asset with little or no risk to your capital (if you hold it until maturity) then you will be less inclined to take a chance in a volatile equity market. You are less likely to want to pay over 20 times expected earnings to buy a share. 16 or 17 might seem more reasonable. And to get there the share price needs to fall by 15-20%. This goes a long way to explaining the trading range that we have seen so far this year for the S&P 500 – and which we are close to the top of currently.
So, if this is the new world investors are living in, what can we do about it? The most obvious strategy, and one that I mention so often that I’m in danger of boring even myself, is to be extremely well diversified. If bonds and shares are marching together, then a 60/40 split just won’t cut it. We need to find investments that hedge against both at the same time. Lots of geographic diversification plus alternatives like gold, commodities, absolute return strategies, cash and property are all likely to feature in the balanced portfolios of this new, harder to navigate, world.
This article originally appeared in The Telegraph.
