Another week, another crisis, another can kicked down the road. The €100m bailout of the Spanish banks was needed to address short-term market concerns ahead of the Greek elections but there are many questions, such as is €100bn enough? What this will do to Spain’s sovereign debt rating and cost of funds? Will this will be seen as a softening of bail-out terms, leading to attempted renegotiation of Irish and Greek deals?
It boosts short-term confidence but does not address the eurozone-wide fundamental issues which are that (a) debts need to be restructured, which means someone has to lose money because they made a bad investment decision by funding banks and countries with unsustainable levels of debt, (b) we are in a vicious cycle of austerity, leading to reduced spending, reduced economic growth and increased levels and cost of debt, which can only be addressed by subsidies from better-off countries (that is, Germany), and (c) euro-area growth needs to be boosted to reduce the debt through a combination of currency devaluation and an improvement in the competitiveness of European economies.
Europe is not the only area with debt issues. The US and Japan, two other major drivers of the global economy, have sovereign debt levels which are unsustainable over the longer term.
What does this mean for portfolio management? First, traditional balanced portfolios of 50 per cent government bonds and 50 per cent equities are unlikely to deliver the returns they have over the last 10 years, especially taking into account inflation, which is what matters for investors. Yields on equities are relatively high (3.97 per cent for the FTSE All Share), government bond yields (1.69 per cent for 10-year gilts) are at historic lows. Taking into account inflation of 3 per cent, the real yield on a balanced portfolio is -0.17 per cent before tax. Any improvement needs to come through price appreciation of bonds (unlikely, given that bonds are expensive by historical standards) or of equities. Given that unwinding of the global credit boom still has some way to go, depressing growth, the medium-term outlook for equities is not promising.
We need to diversify our sources of return. Over the long run, markets pay investors to take risk but in the short run, taking risk on any one asset can result in a loss. We should be harvesting this risk premium from a diversified portfolio including commodities, high-yield bonds, property and alternative investment strategies, such as momentum and mean reversion. Diversification can be achieved by allocating equal risk to each. Most of this exposure can be bought relatively cheaply through ETFs and index trackers.
We can then overlay alpha, which is scarce and often expensive, by allocating some of our portfolio to managers who have a track record of generating real alpha, which cannot be bought by combining ETFs and trackers, as well as including our own short-term views of market opportunities. This is a more balanced way of generating returns in an uncertain environment than just making a bet that equities will go up.
Michiel Timmerman is managing director and chief investment officer at Ignis Advisors