The Constant Investor: What headwinds or tailwinds are investors not paying enough attention to?
Monetary contraction is a positive sign
With the Fed set to tighten again in December and the RBA in play for 2018, there are headwinds aplenty for investors to focus on, but some unlooked for tailwinds as well.
At a fundamental level, rising rates can be detrimental for both equity and bond investors. Companies incur an increase in their cost of financing, which can lower profits and dividends, while fixed rate bonds don’t receive an uplift until they mature and are reinvested.
Adding to these challenges, a gradual process of “credit creep” has meant that more and more investment returns have been generated by being overweight corporate bonds, that is, by taking more credit risk. With credit spreads now narrower, good investors who are well diversified can still expect to earn a fair return on their capital, but not the excess returns seen in recent years.
A further challenge is that both equities and bonds have delivered good results in recent years, and their returns have been positively correlated. While this was a great outcome for past returns, it also reduces the traditional diversification benefits available from asset allocation: as equities and bonds have gone up in value together, they can also go down in value together. Investors must now work harder to achieve true diversification, at both the asset class and sector level.
On a more favourable note, the moves afoot globally to reduce monetary stimulus are a reflection of a more positive economic outlook. As the returns we enjoy on financial assets rely on genuine economic growth to drive innovation, and to meet demand from consumers and businesses, an improving growth environment is signalling a more lasting positive phase for investment returns.
As investors, all we have to do is arrive there safely, and we can increase our chances by reducing reliance on poorly diversified credit, and by being mindful that traditional diversification may be less favourable.
Tamar Hamlyn, Portfolio Manager, Macroeconomics
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