Reward for risk has shifted down across the world but is into negative territory in US equities and bonds, a rarely experienced scenario, Morningstar capital markets head Philip Straehl has said.
He said the firm looked at long-term US valuations to come up with a rough expected return for stocks and bonds.
“A 10-year return on US shares, based on a Shiller PE model, is only four times, and the expected return for bonds as a nominal yield adjusted for three-year inflation was zero to negative,” Straehl said. “It’s interesting if you look at what’s happening; it’s really the first time stocks and bonds are both down to zero [reward for risk].”
It was a substantial drop from normal expectations in asset classes where reward for risk was priced at about 8 per cent for equities, 5 per cent for bonds and 3 per cent for cash.
“The frontier we see today from Australian core assets is that the reward for risk has shifted down substantially,” Straehl says. “In order for us to generate an additional unit of return, you’ve had to take on more risk; that’s the case in Australia and it’s more extreme in the US.”
For multi-asset investors, however, there were some cross-sectional opportunities outside the US, such as global telecommunications companies in Britain.
“Certainly, from a US perspective, the return of the third asset class is cash,” Straehl said. “We’re getting paid [more than] 2 per cent to 2.5 per cent by owning two-year Treasuries and the curve being reasonably flat today. We do like short-term bond exposures today.”
Core fixed income assets are lining up on a frontier of lower reward for risk.
“Two years ago, current assets looked attractive, but now a lot are mispriced,” Straehl said. “We do like emerging-market debt more today than a couple of months ago. We like cash as an ability to hedge against drawdown.”
In Morningstar’s own portfolios, such as the Australian Growth Real Return fund, with a CPI plus 3.5 per cent target, Straehl said the move had been towards cash.
“We are heavily exposed to cash because we think the reward for risk is extreme, in terms of how much you’re being paid for taking on equity risk,” he explained. “Emerging markets as a broad group still feature heavily here.”
The cash allocation of 28.6 per cent of the fund was higher over the last 12 months, in response to inflation concerns. The firm does not have a structural cash allocation and bought cash depending on the business cycle.
“Inflation is more and more a concern for us and cash, in our mind, is a better hedge in the types of macro outcomes we’re thinking about today,” he said.
Straehl defined risk as danger of not meeting the return objective of a particular portfolio; for example, for a superannuation fund, he said, that could be taken to mean the inability of a member or individual to retire.
For Australian equity risk, Straehl saw the Japanese yen as a natural hedge.
“There’s a natural, strong link between the $A and the yen, if you’re looking to control equity risk; having high exposure to yen for an Australian investor is recommended. We have had a higher concentration towards yen,” he said.
Straehl spoke on the topic, “How should fiduciary investors think about the reward for risk?” at the Conexus Financial Fiduciary Investors Symposium, held in the Blue Mountains in May.
