Our quarterly update from the Lighthouse team
Quarterly Update
The strong first half of calendar 2023 gave way to a pullback in the September quarter. Most normal asset classes suffered negative returns, including global and NZ shares, global and NZ fixed income, and listed property and infrastructure. In contrast, cash and short-term bonds fared relatively well, as did select alternative asset classes. The main factor behind the sell-off is concern that interest rates need to be higher for longer. While inflation has been trending lower, it is still higher than central bank targets.
Economic growth and employment levels have also stayed stronger than anticipated in many countries, including New Zealand, Australia and the United States. The silver lining is that this has reduced the chances of a large slump in economic activity, which is ultimately much worse for asset prices than a pull-back caused by activity being stronger than expected.
In addition, higher interest rates mean that portfolios now have much higher income returns than they had a year or two ago. This source of return is much more certain (less risky) over the short term than the return from capital gains.
Short Duration and Diversification
There were some bright spots. So-called cash-enhanced funds and short-term bonds performed well in the quarter given their high running yields of 6% or more. Alternative strategies also performed well this quarter, including insurance-linked securities, trend-following and multi-strategy alternatives.
It is tempting to assume that the rate hike cycle is very close to being finished and long-duration bonds represent great value. As we discussed last quarter, yield curves globally are inverted. This means that the market is expecting short rates to have not just peaked but to begin declining. Our portfolios continue to have a tilt to short duration and exposure to defensive alternatives which have added considerable value over the last two years.
Although a soft quarter is never comfortable, from an overall portfolio design point of view, our greatest concern is when all assets move strongly up or down at the same time. Mixed asset class performance over the short term indicates that portfolio diversification is working. Diversification benefits occur because asset class co-movements, or correlations, are not perfect. The NZ Share market, for example, do not always move in lock-step with global shares. Similarly, global listed property and infrastructure tend to be less impacted than shares by global growth conditions but are more sensitive to interest rate changes. And NZ and global government bonds have historically had a very low, often negative, correlation with shares (government bonds have typically rallied when shares have fallen).
While we can expect diversification benefits from having a mix of asset classes in the portfolio, we can’t expect it to work perfectly all the time. Over 2022, and in the current quarter, longer-term bonds and equities both fell (i.e. were positively correlated). There are also potential limits to diversification. Adding a very volatile asset class to the portfolio that is highly correlated with shares could raise, rather than reduce, the overall portfolio risk.
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James Blair
Wealth Director
+64 27 399 5175
Disclaimer:
The information in this article is general information only, is provided free of charge and does not constitute professional advice. We try to keep the information up to date. However, to the fullest extent permitted by law, we disclaim all warranties, express or implied, in relation to this article – including (without limitation) warranties as to accuracy, completeness and fitness for any particular purpose. Please seek independent advice before acting on any information in this article.
