Defensive Assets – A History Lesson
As part of our asset allocation work, we compared the MSCI United Kingdom (as a proxy for UK equities) with four asset classes typically described as having defensive qualities – UK gilts, global government bonds (hedged to sterling), global government bonds (unhedged) and short-term gilts.
We focused on the worst peak-to-trough drawdowns of the MSCI UK since 1975 and the defensive qualities of the four asset classes are clear when you focus in on the biggest drawdowns that ended in 2003 and 2009. There were some drawdown periods where the asset classes merely protected rather than appreciated, but only in one period (1994) did all four lose money.
We also looked at the price return of gilts in these periods as the carry benefit will clearly be lower today than historically. Excluding income and the contribution of gilts in the drawdown periods is rarely significant – offering capital protection rather than offsetting other losses.
Other fixed income asset classes, like investment grade credit, almost always underperform government bonds in periods of drawdown and do a poor job of protecting clients’ capital.
US dollar
It is a common belief among investors that the US dollar is a safe haven currency and can help protect capital in times of stress. This was most clearly seen in the 2008 crisis when the US dollar delivered extremely strong returns against sterling. Global bonds unhedged returned a staggering 59% in the 2008/09 drawdown against a UK equity return of -38.4%.
However, when focusing on the 10 worst drawdowns since 1974, the dollar doesn’t fare so well, appreciating in only three of the ten periods examined. It is the Swiss franc that fared the best, appreciating in eight of the ten drawdowns.
Fair Value?
For every asset class, Morningstar’s investment management group generates what we consider a fair value based on our long-term analysis. Our fair value for the UK 10 year gilt is between 4% and 5% – clearly a long way above today’s rate of 1.2%.
It seems a long time ago but the 10-year gilt yield was sitting at 3.49% as recently as December 2013. A return to these levels from today’s 1.2% in 12 months would produce a return of -20.9% for the 10 year bond; if it took two years to return to this level, the return would be -9.4% in year one and -8.4% in year two. Clearly these types of return would make a defensive client very uneasy indeed.
However, it would be remiss to discount the UK moving to a German yield scenario. In this scenario, unlikely but not completely unrealistic, the return in the first year would be 13% plus.
In our Morningstar Managed Portfolios, our government bond level is at record lows – and we have been moving assets into cash at the asset allocation level. In 2010, for example, we advised conservative clients to invest 25% in gilts and 15% in cash. This year we’ve reduced the gilt weight to 14% and increased cash to 20%.
Our view is that even with yields at record lows, it is difficult to ignore history and the humble government bond remains one of the better sources of diversification.
