A number of clients have observed recently that returns for their lower-risk client portfolios are exceeding those of their higher-risk portfolios.
This has largely been driven by the huge recent run in bonds, because of quantitative easing and worries about deflation.
Higher returns from supposedly lower-risk assets seem to many observers somewhat perverse and clearly shouldn’t be expected to persist for any length of time.
A key part of our process is understanding risk. Much of financial theory considers risk as fixed – bonds are always less risky than equities and so on.
We, however, think this is an absurd view. Risk is clearly a variable and it is affected by real-world events and, importantly, asset prices.
Arguably we cannot predict future returns but we can manage the risk we take. Common sense should suggest that if you pay a high price for something, your risk of loss is higher than if you pay a low price.
Where have we arrived now in markets? We have got to a point where the theoretically lowest-risk assets offer either very low, or even negative, returns, while the theoretically higher-risk assets appear to offer relatively high returns.
So everything appears to be normal until you dig a little deeper. At present it seems the risk of loss in the lowest-risk assets is actually much greater than in higher-risk assets right across the spectrum.
The very lowest risk asset is considered to be short-dated government bonds and in many cases these are offering a certain loss and the possibility of even greater losses in the event of rate increases.
While the highest-risk assets, perhaps smaller companies stocks, appear to be priced more cheaply compared to larger companies than their historical averages – and equities, in general, seem to have an attractive yield compared to other assets.
It could be argued that this is a perverse effect of quantitative easing, by creating a one-way bet in government bonds. Through central bank bond buying and a determination to keep rates low, bond investors have been right to consider themselves underwritten on the downside.
Credit investors have also been experiencing extremely low losses as the authorities stepped in with quantitative easing to prevent widespread defaults in the last recession. So capital has been sucked into fixed income right across the spectrum, at the expense of riskier assets. This is the complete opposite of the consensus view that equity markets have been propped up by quantitative easing.
Short-term interest rates will eventually rise and, although they are unlikely to reach anything like levels considered normal in the past, the risk of a parallel upward shift in the yield curve is material, which would lead to significant capital losses for bond investors.
If our thesis is correct – that money has been attracted to seemingly low-risk assets because of high rates of capital gain at the expense of higher-risk assets – this eventual ‘normalisation’ could prove beneficial to both the prices of riskier assets and the normal operation of capital markets.
David Jane is a multi-asset manager at Miton
