Perhaps the clearest investment challenge that will endure well beyond Covid-19 is that of how to construct a portfolio in a world of very low government bond yields.
Government bonds have traditionally played two roles in a portfolio. One is to provide a steady and stable source of income. The other is to protect a portfolio in times of market stress. Traditionally, recessions would coincide with central banks cutting interest rates, sending bond prices higher at a time when stock prices were falling. This reduced the overall scale of capital loss in bear markets.
As we look ahead, developed world government bonds don’t look like they will serve either purpose. Even long-duration government bonds provide very little – if any – income in much of Europe. And unless central banks entertain the idea of taking interest rates into negative territory (or deeper negative territory, for those already deploying negative interest rates) then bond prices cannot rise much in periods of market stress.
Meanwhile, shifting to, say, a 90:10 allocation or substituting government bonds for high yield bonds would help boost return prospects but result in a portfolio that was far less able to weather bouts of volatility.
Public and private market correlations
Quarterly returns
Source: MSCI, Bloomberg Barclays, NCREIF, Cliffwater, Burgiss, HFRI, J.P. Morgan Asset Management. RE – real estate. Global equities: MSCI AC World Index. Global Bonds: Bloomberg Barclays Global Aggregate Index. U.S. Core Real Estate: NCREIF Property Index – Open End Diversified Core Equity component. Europe Core Real Estate: IPD Global Property Fund Index – Continental Europe. Asia Pacific (APAC) Core Real Estate: IPD Global Property Fund Index – Asia-Pacific. Global infrastructure (Infra.): MSCI Global Quarterly Infrastructure Asset Index (equal-weighted blend). U.S. Direct Lending: Cliffwater Direct Lending Index. Global Private Equity: Cambridge Associates Global Private Equity Index. U.S. Venture Capital: Cambridge Associates U.S. Venture Capital Index. Hedge fund indices include equity long/short, relative value, and global macro and are all from HFRI. All correlation coefficients are calculated based on quarterly total return data for the period 06/30/08 – 09/30/19. Returns are denominated in USD. Data is based on availability as of 31 May 2020.
The challenge is therefore to find assets that have low correlation to stocks and ideally provide income along the way. While there are still highly rated government bonds – such as Chinese government bonds – that offer modest positive yields, in our view it may be better to look to the alternative markets. The chart above, taken from our Guide to Alternatives, shows the asset correlations. Within liquid strategies, macro funds have tended to do a good job of providing downside protection. Less liquid options include direct real estate and core infrastructure, which both have relatively low correlations to stock markets and offer relatively strong income.
The chart below uses the return assumptions from our long-term capital market exercise to highlight how the use of these alternatives might improve the mix of volatility and return for a portfolio.
Expected returns and volatility for a GBP investor in coming 10-15 years
% annual compound return
Source: Long-Term Capital Market Assumptions, J.P. Morgan Asset Management Multi-Asset Solutions. Expected returns and volatility assumptions refer to the next 10-15 years. Forecasts are not a reliable indicator of current and future results. Data as of 31 March 2020.
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