By Mohneet Dhir, multi-asset product specialist, Vanguard Europe
Rising headline inflation was already a concern for investors before Russia’s devastating invasion of Ukraine exacerbated global supply chain issues. Now, after global equity and bond markets posted negative returns in the first few months of 2022, investors might be tempted to look for other ways to boost returns.
It could be overweighting a certain region or sector, ‘going short’ on duration or even allocating to alternatives to outpace inflation. The truth is, though, that often the best course of action is to stay disciplined with a globally diversified portfolio of equities and bonds.
It might not sound as exciting or as appealing as more tactical approaches but all our experience and research points to broad market diversification being more effective when it comes to achieving long-term investment goals.
Perhaps the first and most important type of diversification is that of equity market risk. Investing in equities is a great way to drive long-term returns, but stock markets are volatile and can lead to big swings in performance. For the most part, bond markets offer a neat hedge against equity market downturns, owing to the broadly negative return correlation between the asset classes.
However, in the past 20 years, the return correlation between equities and bonds has tended to move into positive territory for short periods, before reverting back to a negative state if given enough time.
High inflation is one of the primary factors that can disrupt the negative relationship between stocks and bonds, but it needs to be sustained over a multi-year period. By our calculations, we would need to see annual core inflation in the US, for example, of around 5.7% over the next five years for this to become a risk in the near future, whereas we expect core inflation of about 4.9% in 2022 falling to 3.3% by end 2023.
As the chart below shows, it’s difficult to say exactly which investment within equity and bond markets will perform well from year to year. Although North American equities have outperformed the broader market in the past four years, history tells us that such a trend is rare and unlikely to persist.
Asset class returns can vary
Key bond and equity returns (%), ranked by performance
Past performance is not a reliable indicator of future results.
Source: Vanguard calculations as at 31 December 2021, using data from Barclays Capital, Thompson Reuters Datastream and FactSet. Global equities as the FTSE All World Index, North American equities as the FTSE World North America Index, Emerging market equities as the FTSE All-World Emerging Index, Developed Asia equities as the FTSE All World Developed Asia Pacific Index, European equities as the MSCI EMU Index, German government bonds as Bloomberg Global Treasury Germany Index, Euro area investment grade credit as Bloomberg Euro Aggregate Credit Index, Hedged global bonds ex-euro area as Bloomberg Global Aggregate ex-Euro Aggregate Index. Performance shown is cumulative and denominated in EUR. It includes the investment of all dividends and any capital gains distributions. The performance data does not take account of the commissions and costs incurred in the issue and redemption of shares. Basis of fund performance NAV to NAV.
Rising headline inflation is always a concern for bond investors. That’s because high inflation often leads to interest rate hikes. As the market prices in higher future interest rates, the prices of long-duration bonds are dragged down as the original coupon payment looks less attractive.
Taking tactical positions with your fixed income exposure, like ‘going short’ on duration (i.e., switching to less rate-sensitive bonds often with shorter maturities, before switching back), means changing the overall risk profile of your portfolio. The success of this approach depends on predicting future bank rate movements before the market and shifting your allocation accordingly.
Bonds are there to offer stability against the volatility of equity markets, not to drive returns. That’s why Vanguard bond funds don’t take tactical positions, instead maintaining broad diversification across the maturity spectrum.
Some investors have asked about the credibility of allocating to alternative asset classes as a means of hedging against rising inflation.
Our research found that while gold and commodities offered a better hedge in the short-term (one year) against inflation relative to equities, it came at a price – far higher volatility1.
So, while these investments might outpace inflation – at least initially – they come with increased risk.
Over longer-term horizons of five, 10 and 20 years, equities provided the greatest chance of achieving a positive real return with a lower level of risk relative to gold and commodities more broadly2.
That means long-term investors who are worried about the corrosive effect of inflation might want to consider a portfolio with a greater exposure to equities.
Without a crystal ball, broad diversification makes sense for most investors. Trying to pick and time investments tactically increases risk and requires more time, effort and, ultimately, luck to get it right. And getting it right all the time is nigh on impossible.
By maintaining broad diversification across investment markets, Vanguard funds are designed to deliver value to investors under all market conditions.
1 Source: Vanguard calculations, based on data from Bloomberg and the OECD. Notes: Analysis of the short-term beta to euro-area inflation (use GDP-weighted inflation of Germany, France, Italy and Spain before 1990 as a proxy) and volatility of different sub-asset classes. Volatility is calculated as the standard deviation of rolling one-year annualised returns, at monthly frequency. Inflation beta is defined as how much an asset's return increases when inflation goes up by 1 percentage point. The sample period is 31 January 1976 to 31 October 2021.
2 Source: Vanguard calculations, based on data from Bloomberg and the OECD. Notes: Analysis of the proportion of real five-, 10- and 20-year returns that have been above 0% for global equities, euro-area equities, gold and commodities. The sample period for the monthly data is 31 January 1975 to 31 October 2021. Volatility is calculated over monthly returns of the entire sample period. Indices used: global equities = MSCI World Net Total Return Index; euro-area equity - MSCI EMU Net Total Return Index; commodities = S&P GSCI Index Spot; gold = Gold Spot.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results. The performance data does not take account of the commissions and costs incurred in the issue and redemption of shares.
This document is directed at professional investors and should not be distributed to, or relied upon by retail investors.
The information contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.
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