Regardless of exactly when a correction might happen, it would not be a stretch to say that it’s late in the current investment cycle. And that usually means it is prudent to think about the level of defensive assets in your portfolio.
The problem this time around is that the potential for financial pain may well be high in the very assets that many investors feel are most defensive. This includes assets like bonds, infrastructure, property and blue-chip stocks. Here’s why.
Interest rates have been driven down to never before seen levels, and investors have benefited along the way. That has been reflected in prices for most asset classes, including bonds. We wrote more about the impact of low interest rates and how it might impact the bond market here. Suffice to say that the appeal of owning bonds of any sort, is substantially less than at almost any time in history.
High quality, well-rated bonds are still likely to be in demand and to fulfil their role as defensive assets in a downturn. But the return you’re receiving while you wait is not great. Expected returns on almost all highly rated bonds are well south of 2% per annum, and in many cases at or below zero. They’re an insurance policy that comes with an opportunity cost, and it may well just be easier to keep your money in the bank.
At the other end of the spectrum, higher-yielding bonds and other debt instruments do have, as their name suggests, higher returns. But in our view, those returns no longer compensate an investor for the risks involved in holding them. In most cases, such investments are actively traded. As opposed to high quality bonds, high yield bonds are more likely to fall in value during a market correction, than to rise. This makes them particularly dangerous since they neither deliver attractive returns nor have defensive qualities in a downturn. Proceed with caution in this space.
Large, high quality stocks
Traditionally, late in the market cycle, big boring stocks with stable earnings (e.g. Woolworths, Amcor, Wesfarmers) struggle to keep up with faster growing cyclical stocks. They thus become cheaper, at least on a relative basis. When a market fall occurs, the rush to safety causes these big boring stocks to come back into favour, as equity fund managers and others scramble to buy them for their secure earnings. This means they traditionally fall less than average, which makes them useful to own.
This time it’s a little different. The rise of passive/index investing, combined with offshoots such as ETFs targeting quality or low beta stocks, has meant there is a lot of money chasing these types of stocks. Woolworths currently trades on a price-earnings ratio of 27, and has a 2.7% dividend yield, despite recent problems with employee underpayments. That’s hardly cheap.
In a hefty market fall, those same investment flows that have helped drive the Woolworths stock price 35% higher in the past 12 months, may well go into reverse. The result could well be that these stocks fare no better than average.
Property and infrastructure
In some ways, these are the scariest asset classes of all right now. Property and infrastructure asset valuations are at highs because low interest rates have driven down yields. The lower the cost of debt, the lower the yield a property or infrastructure investor is willing to accept. The longer the income is secure, the lower the yield. Much like the bond market, yields on many assets have reduced to the point that future returns look poor, in the absence of further yield compression. Unless you believe investors will accept even lower returns in the future, it doesn’t stack up.
Prices for unlisted assets have been driven higher by institutional owners, who value the control and low volatility that these assets provide. Prices of listed REITs and Infrastructure funds have been driven higher by the incessant demand for yield. A great number of these listed funds are now trading at substantial premiums to their (already inflated) asset values, exacerbating the problem. The potential for harm in this instance is great. For example, it’s not unrealistic to expect a 15% fall in property values at some stage in the next five years. That will spook the market. A listed REIT or Infrastructure asset trading at a 20% premium (which is very common at the moment) might fall to a 20% discount. Factoring in a 30% gearing level, which is about average, magnifies the problem. That all adds up to a fall in the share price of almost 50%.
Think it couldn’t happen like that? The share price of global shopping centre giant Unibail fell 50% between June 2017 and August 2019. The fall was mostly caused by concerns that their shopping centres could fall in value. In fact, the majority of the portfolio rose in value over that time.
If not these defensive assets, then what?
Of course, the problem with all this is that we’ve just taken away multiple options that would normally help to protect an investment portfolio in a downturn. While it is still perhaps palatable to own some high-grade bonds, what do you replace the other traditional “defenders” with? Two obvious options are to carry more cash and to use some form of portfolio protection (e.g. put options). However, the first guarantees low returns while you want for better value to emerge, and the second can be very expensive. But there are other ways to limit the impact of market downturn on your portfolio. In a future article, we’ll explore this in more detail.
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