Rising interest rates act like gravity depressing the value of all assets – property, equities and government bonds alike. The table opposite highlights the returns from the major four asset classes over the near 2-year period of 2022 and year-to-date in 2023. The combined returns from the four asset classes have been a negative -7.3%.
Government bonds, both fixed income bonds and inflation-linked bonds have suffered the most and that can be explained by the fact that they were priced off zero interest rates in late 2021.
An example might help. If you bought a German 10-year Government bond at €100 in late 2021, it offered no yield (no return) for the life of that bond because interest rates were zero. Quite why anyone would buy a long-dated bond with no return was beyond us in GillenMarkets and we never recommended government bonds for that reason.
The appropriate course of action for the person who wanted no risk at that time was to stay in bank deposits. Despite offering no interest at the time, bank deposits are a different asset class as the capital value does not vary and you benefit when interest rates rise.
Returning to the German 10-year bond you purchased in late 2021 at €100, as German long-term interest rates have subsequently risen to 2.93%, the price of the 10-year bond you own will have dropped to €81 for a temporary loss of 19% (-19.4% in the table above). As your bond will mature in 8 years’ time at €100, your annual return from here is 2.93%. An alternative buyer of that bond in the marketplace today at €81 will enjoy a similar gain of 19% between here and maturity, equivalent to the same annual return of 2.93%. If long-term interest rates are 2.93%, why would that buyer pay any more than €81 for your bond? They shouldn’t, simple as that.
So, rising interest rates lead to falling bond prices. It didn’t take a genius to work out that long-dated bonds issued with zero coupons (because interest rates were zero) had no prospect of a return and could only lead to a loss, if, not when interest rates finally rose. And here we are.
Today, we would still not recommend long-dated EU government bonds. With inflation looking somewhat more persistent than authorities bargained for, they still offer no value, in our view.
Elsewhere, global equities have not suffered as much as one might have thought (with the benefit of hindsight). In the US, that reflects the extraordinary gains made by a handful of US tech stocks in 2023 on the back of excitement around AI (artificial intelligence) and their returns have masked losses among the vast majority of stocks in 2022 and again in 2023. And as the US equity markets account for some 65% of the World Equity Index this phenomenon along with a stronger dollar has propped up returns from the global equity index (in euro terms) in 2023 to date.
Investing for better than bank deposit returns requires patience. Returns don’t come in a straight line. Two consecutive years of losses across the major asset classes is not unusual when you examine history. It’s a further reason why taking a 5-year plus view is essential. Getting despondent and selling at times like this can lead to a permanent loss. At the current time, equities and bank deposits still seem to be the appropriate asset classes to consider and getting the balance right between them is the key. And each person is different in that regard. It’s why we carry out investment reviews, so that we can provide each client (or potential client) with customised advice.
European, UK, Asia Pacific and emerging equity markets all offer good value relative to history and relative to (still) low interest rates. So, on a medium-term view, the risks of poor returns from such equity markets appear low.
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