Bonds Will Protect Against Deflation

Investors should not oversimplify their portfolios by plumping purely for equities - diversification is key when there is risk of deflation around

Emma Wall 21 May, 2014 | 9:50AM
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Emma Wall: Hi, I'm Emma Wall. Recently I was joined at the Morningstar Investment Conference by Old Mutual Asset Management's Head of Multi-Asset, John Ventre to discuss the old equity versus bond argument.

Thank you for joining me, John.

John Ventre: Thanks, Emma.

Wall: So we've had some negativity on bonds already this session, the premise being that the equities are able to offer you a better source of income. Would you say this is true?

Ventre: Possibly, but you don't want to lose too much diversification. Equities are going to work really well in a lot of environments but they're not going to work well in a deflationary environment.

So while we're certainly cautious of bonds, we're not at the place that somehow they don’t really belong in portfolios anymore. Instead we're looking to, I guess, manage some of the interest rate risks within bond allocations, but generally stay invested. I think that's because typically equities are beyond the risk tolerance of a lot of investors when owned as a single-asset class.

Wall: You mentioned there deflation, is this a real risk for investors?

Ventre: I think there are a couple of, I suppose, key drivers that might lead us down a deflationary path. The first is the fact – the realty I guess that the world has a lot of debt, and the presence of lot of debt to be deflationary, because it hampers the ability of people to consume, to spend. It decreases demand.

The other factor I think is a less well understood and that's a technological development. We seem to invent new ways of putting people out of work every year. And while I'm certainly no luddite – technology is great for our economy – it does mean that we might be headed into a period of structurally higher unemployment because of that. And if that's true, that's also going to dampen demand.

So, I guess, I'm more in the camp of saying deflation is a risk rather than saying it's going to happen. It certainly wouldn't be our base case. But fixed income interest rate risk is one of the only ways to protect yourself from a deflationary environment.

Wall: Looking more at the equity asset class, obviously the drivers of outperformance over the last year or so have very much been developed market equities. Can we expect this to continue, and if so, how are you sort of structuring your equity allocation?

Ventre: Well, I think the first thing I would try and dispel is I think there is kind of a common misconception or common oversimplification to treat some markets developed and some as emerging and almost treat them as separate asset classes. In reality, the drivers of emerging markets are very different within emerging markets, just like they're very different within developed.

So, I would sort of be more in the camp of being a bit more granular and saying that there are some really interesting emerging market trades out there. China is extraordinarily cheap at this point. Certainly there is risk, but you're arguably being well-paid for that risk today.

Meanwhile in developed markets, you've got, I suppose, quite a cheap U.K. equity market and economy that's growing reasonably fast. So that looks attractive whereas to us the U.S. looks premium valuations for peak margins. So, I don't think it's simple for us as developed versus emerging, selected ideas in emerging and selected ideas in developed.

Wall: John, thank you very much.

Ventre: Thanks, Emma.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar

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