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14 December 2018
By Tristan Hanson
When weighing up where to invest our money, a common starting point is to look at the investment returns available on two-year US government bonds, or Treasuries. This is because they are widely perceived as risk-free assets, since the US federal government is seen as vanishingly unlikely to default on its debt.
The annual returns on these assets are a key benchmark for global investors. It therefore matters that the yield on holding two-year US Treasuries until they mature more than doubled in the year from September 2017, almost reaching 3% in November 2018.
As global investors, this should force us to soberly weigh up the merits of holding bonds issued by the likes of the German and UK governments that are delivering a negative real yield – in other words, by holding them until they mature you are locking in a financial loss once inflation is factored in.
Over the past couple of decades, owning Western government bonds has very often bailed investors out when stock markets have fallen. When share prices have tumbled, bond prices have held up or risen as investors have demanded these ‘safer’ assets.
A major challenge for investors in 2018 has been that this negative correlation between these two major asset classes has not consistently held true, so a combination of the two alone – which is how many investors typically construct their portfolios – has not offered investors effective diversification. Indeed, in early February 2018, it was weakness in bond markets that can be understood to have precipitated stock market weakness.
I don’t believe that we, as investors, can have a reliable edge in forecasting future events. Lots of unexpected things can and invariably do happen, so why expend our efforts on guessing where markets are headed?
Rational investors can instead be guided by the divergence of asset prices from a reasonable sense of ‘fair’ value – in other words, when assets become too cheap or too expensive. After all, short-term views should matter less than underlying fundamentals over the longer periods that we usually invest for.
When I compare the real yields on global equities and government bonds – including US Treasuries – I find it hard to see why long-term investors wouldn’t take on the additional risks of equities. In particular, I believe there are opportunities across Asia, Japan and Europe.
Italy is a good example of a stock market to which global investors have soured – following Rome’s ongoing budgetary dispute with the European Union – because of investor sentiment. Italian bank shares have taken a particular hit. Yet in the absence of any fundamental change to Italian companies’ prospects, sentiment may recover just as quickly in 2019 and one must ask whether this could be reflected in share prices.
While I believe equity valuations are, by large, more attractive outside the US, this is not to say there aren’t opportunities to be found in US shares, especially after the stock market downturn in the final quarter of 2018.
Indeed, I see a potential fillip for investors. US inflation remains low, so there’s no pressure on the central bank, the Federal Reserve, to lift interest rates to curb demand. If the Fed eases off on raising rates in 2019, I think there could be a surprise upside for US share prices which, to me, don’t look as expensive as some suggest as we head into the new year.
The views expressed by the author should not be taken as a recommendation, advice or forecast.