Mark Burgess, Chairman, Jamieson Coote Bonds Advisory Board

With the prospect of a decade of moderate returns ahead, the quality and skill of your active manager will contribute a much higher proportion of any portfolio returns in the future. To fully appreciate this, you only need to reflect on the recent market environment to see an almost perfect example of what a good investment process requires.

The past 18 months have reminded us of what constitutes quality and skill in investment management – you need to have a clear process with a medium-term view, and you need to stay the course. And, if you did, you benefited from the compounding effect of what were an incredible 12 months of returns.

The challenge of stretched markets

These gains aside, this strong performance has created its own challenges for investors because it lifted all boats. Markets are now up massively, and valuations are very stressed and stretched. When all boats rise it’s a highly correlated outcome across asset classes. Typically, we try to build a mixture of correlations in portfolios to make sure that we've got protection in all environments. It turns out that almost everything went up and that leaves us with a bit of a dilemma today.

And, with today’s high valuations, we almost don't want anyone to give us capital back. So, if you've got money with a venture capital fund and they're giving you money back, the reinvestment problem can become very significant for institutional investors.

Looking forward, the monetary policy response is crucial. However, at least in the short-term, the central banks don't really have a plan. They have a general idea of what they need to do, but they are less confident about repositioning to get interest rates slightly up.

Central banks will be reluctant to remove monetary stimulus because they've been hurt in the past by the volatility that it will create. This hesitance coupled with continuing uncertainty in fiscal policy around reducing deficits and avoiding fiscal cliffs adds to today’s challenges.

Capital crowding around ESG and climate

While Australia looks set to come through the pandemic in pretty good shape, we need to consider what the significant drivers will be for long-term economic growth. In doing so, investors need to carefully consider the role of climate change and environmental, social and corporate governance (ESG) factors.

Despite this pandemic, institutional and private investors have quite correctly become very focused on the climate, but also on using the right style of investment to achieve positive outcomes, such as impact and ESG-driven strategies.

The risk in asset allocation is that we may get crowding of capital as it shifts all the way across to ESG areas. Investors will crowd each other out and force a lower rate of return by overinvesting in the short-term. Interestingly, on the flipside, there are some areas in the oil markets providing strong returns which are now underinvested.

Be wary of low volatility

Believe it or not, the one thing that we've got used to over the past 30 or 40 years is low economic volatility. It’s strange, given that we had the 2008 correction, and we've just had a major volatile event in the global economy, but people have got used to somebody stepping in to prevent the volatility.

One of the reasons why investors responded so quickly is because they had confidence that central banks would prop up the markets and create low economic volatility.  But there are signs that the low economic volatility environment maybe becoming stretched – at least at the margin.

It’s important to emphasise volatility, and not just interest rates – because if you have high debt on your balance sheet, volatility is a very dangerous thing to have around you. The risk is we’ve got used to the ‘great moderation’ over a very long time with low volatility, but volatility exists in other forms, such as within supply chains, inflation and geopolitics.

For example, China is now trying to restructure its economy, which could trigger a very volatile environment if something goes wrong, so investors need to remain alert on many fronts.

Future focus on a good investment process

In this environment, effective portfolio construction and diversification rely on a good investment process and correctly evaluating what makes a truly defensive asset. Institutional investors are putting a lot of thought into this question and coming up with relatively few answers. In my mind, bonds will remain a diversifying asset for portfolios while also providing defensive ballast.

This year is the 40th anniversary of the peak of interest rates, and since 1981 we’ve witnessed a secular decline which has created a tailwind for some investors. Whenever you get a secular decline in anything, it creates a series of habits or behaviours. There would never have been a better environment for a portfolio’s long duration assets, such as property investment, and it has truly been a golden period for investors simply because of the trend.

In the next decade, however, interest rates will probably trade sideways, no longer supporting returns in long duration assets. COVID-19 gave another kick to declining interest rates and we're back to where we started. Therefore, your active fund manager’s skill, technique of investing, and selection of assets will now be far more important in generating future income as we're setting ourselves up for at least a decade ahead of moderate returns.