After a period of near-zero interest rates and prevalence of the ‘There is No Alternative’ (TINA) narrative around owning equities, multi-asset investors can finally rejoice that there are multiple alternatives to broad developed market equities.
Particularly after 2022, one of the worst periods on record for bonds and a period of shock for many investors believing their portfolios were robust against drawdowns, this type of uncertain market is the perfect time to consider ways to add ballast to a portfolio which does not rely on the recent obsession over equity market exposure.
Today we’ll explore a few assets that we believe offer some attractive allocations within a well-diversified portfolio, and consider how they might offer differing profiles to a simple developed-market equities exposure.
Bonds Are Back
Although generally yielding less than cash, investors are now being paid to hold bonds in their portfolio in the form of coupon yields – as recently as 2021, many bonds had a near-zero or even negative coupon, even US Treasuries were around 1.0%:
Source: Bloomberg, Innova Asset Management
Besides paying a modest income, we believe that this increase in yields has an even more important effect on multi-asset portfolios: bonds should serve as a hedge again.
Why is this? When interest rates were zero (see chart below on global interest rate levels), bond yields were also low and therefore had very little room to provide capital upside – remember bonds make capital gains when interest rates/yields fall.
Source: Bloomberg, Innova Asset Management
No room for rates to fall, no room for bonds to make gains, therefore they are an ineffective hedge against a falling equity environment. That was obvious to anybody who held interest-rate sensitive assets of any kind in 2022:
Source: Bloomberg, Innova Asset Management
In 2022, with interest rates starting at 0 and bond yields at similar levels, bonds had no room to rally AND structurally were losing value since global central banks had to raise rates from these historically low levels to fight inflation. The effect is plain to see in the chart above, starting from point A.
However, once interest rates had moved to higher levels, as had bond yields, their hedging relationship was re-established. Notice point B, the 1.0%+ rally in short-term US Treasuries came on the back of the Silicon Valley Bank crisis and subsequent sell-off in equities.
The dynamics were obviously nuanced, involving expectations around Fed hikes turning into cuts, banking system fragility reminiscent of 2008 etc., but for the first time in several years bonds acted like the hedge people expected them to.
Going forward, as we maintain higher interest rates and bond prices have more room to move, we expect the hedging nature of bonds to stay, which adds enormous value to a portfolio when considering alternative exposures to simple equity exposure.
Emerging Opportunities
Emerging markets are an area that are signalling significant growth opportunities ahead, whether you consider better demographics, increasing per-capita GDP or simply valuations – the subject of today’s note.
After a period of significant outperformance in the late 2000s/early 2010s, Emerging Markets have never quite regained that same lustre to global investors, more fluctuating around ‘par’ with Developed Market performance. Today we see a situation where the underperformance of EM versus DM is the lowest since the GFC, and is at levels which generally preceded a meaningful rally:
Source: Bloomberg, Innova Asset Management
From a price-to-earnings (P/E) perspective, EM is looking relatively cheaper than MSCI world, trading at 12.6x versus 17.9x, and relative to its own 15-year history also looks undervalued versus fair value for developed markets:
Source: Bloomberg, Innova Asset Management
Source: Bloomberg, Innova Asset Management
Another interesting comparison is in the leverage between these indexes, particularly when considering we’re in a higher interest rate environment with the potential for an economic slowdown in the near future. As a proxy for leverage, we’ll consider price-to-book (P/B):
Source: Bloomberg, Innova Asset Management
Source: Bloomberg, Innova Asset Management
After a significant de-leveraging cycle, Emerging Markets are now trading relatively cheap on a P/B basis, whilst MSCI World looks very expensive to its history and on an absolute level.
Emerging Markets is of course a very broad term, and within such a vast universe there are many markets which fare better than others – within the Innova portfolios we are current holders of select China, Korea and Japan exposures particularly. However, as a broad asset class, we believe EM holds value in the future and offers investors a compelling alternative equity allocation to only holding Developed Markets.
Bigger Isn’t Better
Finally, we can turn to small caps, the favourite topic of many client meetings and dinner conversations – but aside from offering the chance for high-octane stock picking opportunities, Small Caps as a market have begun to offer an attractive alternative to typical Large Cap allocations.
The Size factor is well-documented across many equity markets, here we can simply chart the performance between MSCI Small and MSCI Large (in Australia, Globally, and the US) to get a sense of the relative ‘valuation’ for small caps as a factor exposure:
Source: Bloomberg, Innova Asset Management
Source: Bloomberg, Innova Asset Management
Source: Bloomberg, Innova Asset Management
Looking at these factor charts, we can see that Aussie size looks around fair value, if not trading at a slight premium, whilst Global and US size looks far more attractively priced.
Again, small companies is another area where there is nuance, and is generally best navigated by an active manager who can appropriately identify those firms which have genuine growth potential – but on a factor and valuation basis we see Small Caps as offering a potential alternative to investors at the appropriate time, this is very much a ‘watch and wait’ exposure until such a time that we get a clearer picture of whether global economies will enter a cyclical slowdown.
There Are Many Alternatives (‘TAMA’)
Now that we have entered an environment which risk-free rates are above zero, and the best approach is no longer ‘buy large cap tech and go to sleep’, many alternatives have presented themselves to the astute investor.
We are actively researching and scrutinising the ideas we discussed today, but this is by no means an exhaustive list of attractive alternatives to large cap, developed market equities in a portfolio.
Consider what might complement such exposures, which will do well in environments where equities do not, and of course if we do pull off a ‘soft landing’ ideal world, what will still be an acceptable allocation in your portfolio regardless of their hedging attributes?
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