The importance of the horizon
If your investment objective can afford a medium-term horizon, the outlook for bond returns is reasonable, given where yields are. It’s not great but better than this year’s outcome and might possibly beat inflation over the next five years. To meaningfully boost medium-term returns, equity exposure is required. It’s just not that clear that today’s entry level is perfect. It never is but the short-term outlook is for recession and reduced corporate earnings growth. That, however, doesn’t necessarily mean much. Look at markets today. A sentiment-driven bear market rally? Maybe. Maybe investors will want to wait for another setback which more Fed hawkishness might deliver. The entry point is important but always keep in mind that the time horizon is as well.
A year like no other
It’s been a tough year for investors. Taking a representative global aggregate bond index, the worst of the total return losses this year wiped out all the gains in the index since the end of 2015. For the MSCI World equity index, this year’s losses took us back to the index level at the end of 2020. In that respect, it has been a worse year for bond investors. Psychologically, that is the case as many of my conversations with clients this year have been about the shock of losing so much in an asset class that was supposed to be safe.
There is no point crying over spilt milk though. Investing savings in capital markets is always a risky business and outcomes in the short-term are determined by the dynamics of the global economy and the policy actions that governments and central banks take. These are things that investors can’t control. Now it is important to look forward. Investment objectives might need to be reassessed given the losses of the last 12 months and that could mean some changes to investment strategies. But in the end, it still comes down to the question of how much risk investors are willing to take to try and meet their investment objectives – retirement incomes, ability to make future purchases, college funds and so on. Outcomes, risk tolerance, time horizon and diversification – the basic building blocks for investing.
Crystal balls don’t work. However, we can make some informed judgements about where best to deploy savings streams given what has happened recently to the valuation of asset classes and potential drivers of risk. Long-term bond returns since the 1980s have been around 6-7%. Since 1990, once inflation had fallen sharply (and leaving out 2022), they have been between 5-7% (using governments bonds and generalising across developed markets). A lot can happen to influence returns in the short-term but taking a five year horizon, returns in bonds tend to be dominated by the initial yield of the portfolio. Historically, 5-year compound annual returns from a US Treasuries index when the initial 10-year benchmark bond yield has been around 4% have come in between 4% and 6%. I don’t think you could go much wrong from thinking that over the next five years that is a good benchmark for return expectations from risk-free bonds. The analysis gives similar results for UK and European bonds.
Medium term bond returns
Is 4% to 6% a year enough? That return could be boosted a little by focusing on corporate bonds with some additional yield, but also a little more risk. If inflation is going to return to 2%, then fixed income looks reasonably attractive for the low-risk base of a savings portfolio. This year has been an exception and, going forward, we are very unlikely to see a period in which global interest rates go up as much as they have since the beginning of 2022. But inflation might not go back to 2% anytime soon, so real return expectations might necessarily be modest. Bonds are relatively attractive compared to recent years but, compared to previous decades, yields on risk-free bonds are still relatively low. Return expectations have to be set accordingly for those investors with more than a short-term horizon.
Credit should boost them
Most non-government fixed income assets offer a yield substantially above government bonds today. In Europe, the average corporate bond index has a credit spread of around 180 basis points (bps) above government bonds to give a total yield of 3.76%. Historically, that has generated returns over subsequent 5-year periods of (on average) 4%-5%. The range is wider though because credit spreads move, often in the opposite direction to rates. However, today’s spread and overall yield levels in credit suggest reasonable returns over the medium term. The more extreme case is in high yield markets where current yields suggest positive returns over the next five years but in a range that has been historically, -2% to +10%. Our view is that this is likely to be towards the top of that range going forward.
But what about the recession/Fed/oil…?
This is all a bit dispassionate because most of the market commentary is fixated by how long the central banks will remain hawkish and how deep the recession is going to be. Few people believe the current rally in risk assets because the news is about the cost-of-living crisis, war, de-globalisation and climate change. The gut feeling is that investors should not be getting positive returns when the news is so bad and so many people are suffering from a challenging global economic climate. The gut feeling is then that more losses are more likely than significant positive returns. Yet, it is always hard to accurately map market returns against the economic cycle. It is also hard to accurately internalize structural change and investor behaviour into market expectations. That’s why markets are always surprising and why there is no free lunch in investing. I shy away from the phrase “it’s all in the price” as, quite frankly, we never know what the “all” is. One would assume, however, that most people that are in a position to invest, dis-invest or stay in cash have a pretty good idea of the narrative of the outlook for 2023. How they all respond to that is anyone’s guess.
Hard to focus on the long-term
Having said that, the point is that the news and the outlook means there is less visibility than usual about real returns, volatility and corporate cash-flows, as well as the macro-economic indicators. So focusing on the medium-term and trying to set expectations based on today’s valuations is helpful when there is no way of knowing how asset prices are going to behave in the next six months. I once worked with someone in the US who was a Vietnam Veteran and a chartist. He said that he only looked at markets once a week and only ever looked at the charts – disregarding all the fundamental and other noise. I’m not saying I agreed with him but there is some value in standing back from time to time. Trying to explain every percentage move in stocks or basis points move in bonds does little to help understand how to generate long-term investment returns.
Entry point for stocks?
Fixed income traditionally offers more stability of returns. That is because of the nature of the contract (fixed terms, mostly fixed rates, senior in the capital structure, etc). Usually permanent losses in bonds are because borrowers are fraudulent or have business models that should never be in a position to borrow money in the first place. In equities, there are more risks. Historically, returns have been higher – US equities have generated annual compound returns of around 12% – but there is also a greater range of outcomes. Some businesses have more stable revenues, better managements and pay dividends to shareholders regularly. Others don’t.
Pressure on cash-flows
The Fed’s staff think a recession in the US in 2023 is a 50:50 bet. There has been a fairly aggressive tightening of policy and because it takes time for core inflation to come back down, rates will remain high. That means slower credit growth and more cash-flow diverted to servicing debt. Good and bad news for banks, generally bad news for households and corporates that have debt. While medium-term bond returns are determined by yields (in turn determined largely by the stance of monetary policy) returns in equity markets are much more dependent on the economic cycle and the relationship between starting valuations (price-earnings levels) and subsequent medium-term returns is less robust than in fixed income markets.
What is driving the rally at the moment is sentiment. Peak inflation and rates and some other factors have changed the gamble in the short-term. My concern is that the Fed will look at how things have developed since October and conclude that financial conditions have eased too much and will again ramp up the hawkishness. This doesn’t mean a 75 bps hike in December, but it may mean a reiteration of the view that some more tightening is needed, and rates will remain higher for longer. The new year will see that game of chicken continue. I’m not sure that equity investors will necessarily be the first to blink. Bonds offer more surety of positive returns, equity markets are still likely to do what they do…generate volatility. Most investment outcomes will benefit from having both and, importantly, time.