A cursory glance at major asset class investment returns for the year 2020 as a whole may reveal little that was exceptional. Many “balanced” investment strategies produced rates of return quite close to longer terms averages and expectations. The fixed interest asset class generated just under 5% for the year, with a basket of local and global equities producing a similar result (subject to currency hedging levels).
As we know, however, 2020 was an exceptional year on so many fronts. For investors, it delivered the most rapid equity price decline and recovery on record, as financial markets digested the implications of the COVID-19 pandemic and subsequent unparalleled policy response. The collapse in share prices in March was quickly reversed as investors concluded that the tragic impact of the pandemic would be for a limited period and that most listed companies could remain solvent and profitable, given magnitude of policy support being provided to the wider economy.
Central to this policy support was a huge injection of spending from governments around globe, as well as the extension of monetary easing that brought near zero interest rates to Australia for the first time. Underpinning the rationale for this policy response was a mounting belief that in an environment of low inflation there are few limits on the magnitude of policy stimulus that can be absorbed by an economy.
Across the growth asset classes, 2020 produced some highly disparate results.
Despite the tail wind of lower interest rates, property and infrastructure significantly underperformed with negative returns posted for the listed versions of these asset classes.
Shopping centre lockdowns, a collapse in the demand for transport infrastructure and questions over the longer term future use of office space are some of the reasons for this underperformance. Within equities, there was also a high degree of variability in returns across companies and industrial sectors. Companies with higher than average earnings growth prospects tended to benefit the most from low interest rates as there is less “penalty” for the time delay applied in the valuation of future year earnings.
In addition, although some businesses were clearly negatively impacted by lockdowns and the broader earnings implications of COVID, others had positive experiences with COVID acting to either change business models or accelerate changes that were already in train. As a high growth sector, Information Technology (I.T.) was a standout in terms of return in 2020, sitting at the intersection of the positive influence from low interest rates as well as the business model changes being brought about by COVID.
The relatively small size of the I.T. sector in Australia is one factor explaining the lower return on the Australian equity market last year. Negative returns from banks were another contributor, as share prices were sold down and banks were forced to cut dividends in response to higher provisions for bad & doubtful debts.
However, there has been lack of widespread corporate default and strengthening residential housing prices have minimised any damage to bank profitability. None-the-less, the banking sector in aggregate remains cheaper than it was at the start of the year.
The year ahead
The rally across global equity markets since the end of March 2020 has arguably led to shares being priced for perfection. Underpinning current valuations is an assumption that the global economy will recover strongly from the COVID induced recession, which in turn implies an assumption of a successful vaccine rollout and an orderly wind down of policy support.
Also assumed is a maintenance of low inflation, allowing for a continuation of near zero interest rates, despite the impact of the unprecedented monetary and fiscal policy stimulus injected in 2020. These assumptions may well hold, providing scope for another positive year on equity markets. However, given the uniqueness of the scenario unfolding, the margin for error allowed on any economic related forecast must be relatively high. The change of administration in the world’s largest economy this month only adds to this degree of uncertainty.
Hence in setting investment strategies for the year ahead, a higher than normal degree of caution may be warranted.
Unfortunately, the traditional use of cash and fixed interest asset classes as portfolio risk mitigators appears less compelling now that interest rates have fallen below expected inflation.
However, the lack of appeal of interest bearing assets should not be a trigger to abandon the pursuit of diversification of investment exposures. Cash and other interest bearing assets can still play a role in providing a source of capital stability in portfolios, and provide a potential source of funding should opportunities emerge to purchase growth assets cheaper in the future. Other sources of diversification to complement equities may, though, need to receive more consideration if portfolio return objectives are to be met.
Three potential sources of diversification that could play a more important role in portfolios over 2021 are discussed briefly below:
Infrastructure - after being sold down heavily in March, listed infrastructure remains 12% cheaper than it was 12 months ago. With many investments in this asset class offering stable cashflows, investor support may grow as alternatives to fixed interest investments are sought. The inflation linked nature of cashflows adds to the attractiveness of the asset class, given that higher inflation is one of the potential risks associated with bonds and equities more generally.
Unhedged currency exposures – with the Australian dollar rallying strongly to over US 77 cents at the time of writing, the merits of holding global assets on an unhedged currency basis have increased. Unhedged currency exposure has been a valuable source of diversification in past periods in which equity markets have corrected (due to the tendency for the $A to decline when there is a broad based equity market sell-off).
Alternatives – the use of alternative investment strategies (e.g. hedge funds), where returns are essentially sourced from manager skill rather than the direction of any underlying asset class, has been problematic for retail investors in the past due to high complexity, high fees and opaque performance. However, the quality of available investment products has improved over recent years. With interest rates now so low, the “hurdle” return required for Alternatives to produce improved risk adjusted outcomes in portfolios is more achievable.
The following indexes are used to report asset class performance:
ASX S&P 200 Index,
MSCI World Index ex Australia net AUD TR (composite of 50% hedged and 50% unhedged),
FTSE EPRA/NAREIT Developed REITs Index Net TRI AUD Hedged,