This article is written by Gazal Jain- Associate Fund Manager- Alternative Investment Quantum AMC
Covid-19 has changed life as we have known it. Everything from how we work, socialize, and communicate to how we shop is in the midst of a transition. But have you stopped to think about what change the health crisis is bringing to the world of investments? Well, it is going to have a lasting impact on the traditional 60-40 asset allocation that most investors subscribe to.
In the pre-pandemic world, bonds may have zigged when equities zagged. But this might not be true in the future, making it imperative to revisit a longstanding investment tenet: the use of bonds as a diversification tool against equities.
The problem of high risks and low rates
The economic havoc wreaked by the coronavirus pandemic has plunged the global economy into a recession. Governments and central banks have unleashed trillions of dollars of stimulus to prop up economic growth. Interest rates globally are being reduced to near zero to make money cheaper and encourage people and businesses to borrow and spend and invest.
With widespread unemployment, wealth destruction and risk of more waves of infection, hopes of a quick economic rebound are now getting replaced by expectations of a W shaped recovery and speculation that more policy action may be needed
In spite of this, equity markets have been soaring. Sensex P/E in July is back to February levels of 24, when Covid-19 had not yet reared its ugly head. This disconnect between financial markets and the real economy is most likely based on the liquidity tsunami and expectations of continued support by central banks. This mispricing of risk and resulting rally in the equity markets could derail as and when the ground realities emerge or risk-off sentiment returns, increasing the chances of a pullback in equity prices.
Central banks continued to remain accommodative for six years following the Global financial crisis of 2008 and this is many times more severe than that. This tells us that monetary and fiscal policies around the world will continue to be accommodative to boost GDP growth for the next few years.
Already, as per the IMF, global public debt is expected to exceed 100% of GDP in 2020–21, up from 80% last year. And the average fiscal deficit is expected to touch 14% of GDP in 2020, up from 4% last year. This is an unprecedented rise, and there is more coming. Low debt servicing costs are the only way to manage these debt levels that have grown too large to be managed.
Thus bond yields and short-term interest rates are bound to stay low for the foreseeable future, reducing expected bond returns.
As of now, we have sub-zero rates in parts of Europe and Japan and US Treasury bonds now sport rock-bottom interest rates with the US 10-year note now yielding a paltry 0.63%.Closer home, the RBI repo rate now stands at 4%, the lowest it has ever been. The India 10-year bond yield is currently yielding 5.83%, the lowest it has yielded in more than a decade.
Short-term and high-quality bonds now have low rates and limited upside. Investors can opt for higher yields through longer term or lower-quality bonds, but will end up taking on duration or credit risk. Even there the potential for bond price appreciation isn’t much considering that rates are at all-time lows already.
So effectively, bond investors are staring at low annual payouts as well as limited price appreciation going forward. This is making investors question bond markets’ ability to act as a hedge against equity price volatility as it has traditionally.
To add to woes, a low interest rate regime coupled with an outlook for high inflation is making investors question whether their meagre returns from bonds will beat rising inflation going forward. Already, the Government of India 10 year bond is yielding below CPI inflation of 6.09% as of June 2020 data, and lower maturity bonds are bearing even lesser.
Gold to the rescue
Interestingly, the same macroeconomic factors of heightened risk, low interest rates and high inflation are increasing the portfolio relevance of another asset class - gold.
Heightened risk makes investors seek stability of risk-off assets like gold which have zero to negative correlation with risk assets like equities. This feature of gold makes it lower portfolio risk and aid in stability of portfolio returns Additionally, lower interest rates make non-yielding gold more attractive to hold. What makes the case for gold even stronger is that historically gold has excelled in periods of low interest rates, providing the ancillary benefit of price returns. Gold’s outstanding performance following the GFC of 2008 is recent evidence of that. Lastly, gold has historically remained a relatively stable purchasing power, making it a preferred asset class in times of high inflation.
Thus in the current scenario, gold, with YTD returns of 25%, can be more useful than bonds in alleviating equity risk, diversifying the portfolio and helping investors achieve long-term investment objectives by beating inflation, warranting a higher portfolio allocation to gold than held historically.
Bonds usually make up a major chunk of investment portfolios, and while it’s not practical for investors to fully replace all bond exposure with gold, the environment warrants augmenting gold exposure.
Covid-19 has indeed increased the portfolio relevance of gold and reduced that of bonds for the foreseeable future. No wonder then that investors worldwide are adding gold to their portfolios and global gold-backed ETF holdings have reached new highs of 3,621 tonnes.
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