The Risk-Return Matrix

The surprise victory of Donald Trump in the US presidential election has added fuel to the reflation trade that began in the September quarter. While US stocks have responded positively to reach record highs, the most notable move in markets has been in bond yields. US Treasury yields set the tone for a continuation of the sell-off in bonds that has spilled over into yield “proxies” such as A-REITs and defensive industrial stocks. 

While we had not expected a Trump victory, the ideas that inflation risks were rising and central-bank suppression of bond yields had gone too far were important themes that we had increasingly reflected in our portfolios. The most visible representation of this thinking was our relatively high cash holding, a position based on a view that capital losses on bonds were inevitable and while we expected a low return on cash, it would be better than the losses on bonds. Bond proxies (such as A-REITs) have also suffered from significantly extended valuations and they remain vulnerable to a significant repricing. 

The challenge for investors is that valuations on most assets are at best fair, and, in most cases more demanding, meaning the risk of loss in many assets is elevated. In the context of our investment framework where we assess medium-term (three-year) return expectations against risk measured as a composite of the risk of capital loss and the potential size of that loss, there are limited assets offering appealing returns for the risk embedded in owning these assets. 

In this framework, broader Australian equities stand out as offering reasonable medium-term returns given undemanding valuations. At the other end of the spectrum, we remain concerned about A-REITs (even though they have performed poorly of late) as valuations remain stretched and their sensitivity to small changes in bond yields remains high. Interestingly, while sovereign bonds offer poor return prospects the potential for big losses from owning bonds is relatively low. On balance, the concentration of assets in the lower left-hand quadrant is consistent with retaining a conservative stance notwithstanding enthusiasm around a Trump presidency. As we have seen during the campaign, the reality and the rhetoric may be poles apart. 

The Risk-Return Matrix 

As at 30 November 2016.


The Risk-Return Matrix shows the attractiveness of key Australian and global asset classes. Likely returns are judged on an absolute-return perspective. Risk is based on the likelihood of capital loss.

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