Key investing lessons from 2022

Seldom has there been a year like 2022 for positive stock/bond correlations – a fact that pulverised traditional 60:40 equity/bond portfolios. Data in the Credit Suisse Global Returns Yearbook 2023, compiled by Professor Elroy Dimson (University of Cambridge), Professor Paul Marsh and Dr Mike Staunton (both from London Business School), shows that on only a handful of times since 1900 has this traditional asset diversification failed more badly than last year to protect investors.

The strategy suffered a 31 per cent peak-to-trough fall in US dollar terms, shattering the confidence of many asset allocators who had relied on it their whole careers.

By definition, investing is about looking forward, but understanding the past is invaluable and the yearbook authors have pulled out some essential lessons. Investing during interest rate hiking cycles, periods of persistent inflation and the power of commodities to aid diversification are highlights of this year’s analysis. For younger investors, there is a crumb of comfort, too: the valuation reset of 2022 has at least improved the outlook for generation Z’s future rates of return. Those needing to make good on meme stock losses will struggle, but any new investors who missed that folly now have a more attractive entry point for sensible long-term compounding.

Next to the baby boomers, however, younger investors can feel hard done by, as can the millennials to a lesser extent. Although it must be said that emerging from the rubble of the second world war, the academics muse it is unlikely any survivors expected their offspring to enjoy the returns they did.

Inflation, stagflation and rate hikes

Between 1900 and 2022 the world equity risk premium (ERP) in US dollar terms has been 4.6 per cent over US treasury bills (very short-term risk-free government debt) with stocks making an annualised real rate of return of 5 per cent versus 0.4 per cent for bills. One sobering statistic from the review is, looking at the US in isolation between 1914 and 2022, the lion’s share of equity premium over bills was earned in periods of rate falls. For the UK, the premium between sterling-denominated shares and local bills has been earned almost totally in rate-easing cycles.

The latest US core inflation data was disappointingly high and hopes of rate cuts will be on hold if it remains sticky, even if the rate of increase is past the high water mark. This is worrisome, especially coupled with the meagre outlook for growth. Stagflation – the combination of recession and high inflation – leads to negative returns for equities and bonds, but even middling growth and high inflation have historically provided a backdrop to weak performance by both asset classes.

Last year showed emphatically that inflation is bad for bonds: 2022 hit a new low for the entire yearbook survey from 1900. As the academics make the case, the equity-like returns from bonds from 1980 couldn’t continue indefinitely and the bubble was popped spectacularly. “Those 40 years [until the end of 2021] were a golden age for bonds, just as the 1980s and 1990s were a golden age for equities,” the authors wrote. “[But] golden ages, by definition, are exceptions.” 

Are commodities the saviour for portfolios?

Investors fearing another savage year of positive correlation between equities and bonds may look to other asset classes, but there is no free lunch. The yearbook’s focus segment for 2023 is on commodities, which can provide respite from stocks and bonds but remain highly volatile and shouldn’t comprise more than 10 per cent of a portfolio (arguably closer to 5 per cent is more sensible). The research shows commodities have suffered some nasty drawdowns in value and are vulnerable to recessions.

The overall correlation with shares is weak but still positive, and an undiversified exposure would leave investors vulnerable to combined selling in shares and GDP-sensitive commodities, such as copper. Those caveats made, commodities are demonstrably a hedge for bonds and against inflation.

Commodity futures exchange traded funds (ETFs) are the practical way for private investors to get exposure, but it's important to be discriminating. The academics find that the volume weighting of futures indices can lead to cyclical overexposure to individual commodities: it is far better to find an equal-weighted index that spreads risk across a variety of energy, minerals, metals and resources.

Gold has been a poor long-term investment, with $1-worth of gold in 1900 worth $2.50 at the end of 2022, according to the report, compared with $1 in shares going to over $2,000, but it said the precious metal had provided a “potentially valuable hedge against inflation” since the early 1970s when it was de-pegged from the US dollar. 

Large and lengthy drawdowns of commodities can never be ruled out and, given the confluence of shocking events – including war and the pandemic – that have befallen the world in the past few years, next phases and other grim scenarios cannot be ruled out (deflationary sell-off, anyone?). That all said, as the study that encompasses the horrors of the early 20th century can attest to, there is always room for optimism. Investing overwhelmingly pays off: it’s just that the good luck of the baby boomers should be viewed as exceptional rather than the rule.