Bonds vs Equities – Don’t drive down the road while staring at the rear view mirror

There has been much commentary in the media recently about the world economy and how this has affected investment markets. This undoubtedly raises concerns for many investors, so we’ve obtained commentary from Richard Cole, fund manager with Future Money Ltd, our core investment proposition provider, and his more upbeat overview is provided here.

October saw a surge in equity volatility after a remarkably calm patch for global stock markets. Significant falls were experienced in equities while gilts gained as fear over the strength of the global economy spread. At times like these it is easy to get carried away with the negative sentiment, but we believe that it is important to focus on the fundamental characteristics of different investment classes and, by doing so, opportunities of attractive valuations can be identified.

It is our view that the global economy will continue on its current path of expansion. While significant areas of weakness remain and threats are present, we believe the strength of the world’s two largest economies, USA and China, as well as that of the UK will ensure that growth is maintained. We therefore believe that recent pessimism has been misdirected and that investors are failing to properly identify value within the markets. 

Currently, Britain has significant GDP growth and falling unemployment, both of which strongly indicate economic expansion. Interest and inflation rates are subdued, but we believe they are set to rise as growth continues. In such an environment, it would typically be expected that assets with the ability to grow their earnings above the rate of inflation, such as equities, will produce higher investment returns than those with fixed returns, such as bonds.

While this expectation should always be considered in line with the relative valuations of different asset classes, at present we believe it to be accurate and so we favour equities over bonds in the Future Money funds.

Bonds, and especially those issued by the UK government (gilts), have experienced strong returns over recent years. However, as a result of the fixed income offered by these assets and their pre-defined maturity values, their current high valuations mean that future returns, as measured by yield, are reduced. When these low yields are combined with increasing interest and inflation rates, the fixed return of bonds become less attractive and significant losses can be experienced, even by those assets previously considered as ‘defensive’.

In contrast, equity markets currently trade at generally reasonable valuations and given their ability to increase earnings we expect them to offer the best prospects for growth over the medium and long term. While short term volatility may raise levels of discomfort, we believe that stock market falls, such as those experienced in early October 2014 are good opportunities to increase equity and reduce bond allocations and, as such, we are reminded of the simplest rule of investing: buy low, sell high.

This article is based on the opinion of Future Money Ltd and should not be considered as an invitation to invest or be inferred as investment advice.

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