One such opportunity is Treasury bonds, which Bernstein said serve as an effective diversifier to equities. Treasury bonds have been negatively correlated to equities in the recent past, he said, and they can reduce the risk associated with an allocation to equities.
“Treasury bonds have been a tremendous risk reduction tool the last five to seven years and worked very consistently,” he said. “But yet, people hate Treasury bonds.”
Montier, however, said bonds are “doomed to give you a low return no matter what happens.” If the Fed continues its monetary easing, bonds will offer negative real returns. If the Fed tightens, rates will rise and produce the same outcome. Only in a deflationary scenario would bonds offer attractive real returns, he said.
Investors shouldn’t overrate the diversifying value of bonds, according to Montier. When measured over a time horizon of longer than seven years, Treasury bonds have actually been positively correlated to equities, he said.
But Montier said investors should not be forced into a conservative allocation simply because they fear the Fed’s actions. “In every cycle there is a period of time where there is uncertainty about a change in Fed policy, and whether fundamentals will be strong enough to offset the negative effects of rising rates,” he said. “In this cycle it is no different, although it is a bigger issue because the Fed is more involved.”
One reason to hold bonds is that rates may continue to fall. Bernstein said the Fed is “always late” and will again be extremely late when it does tighten its policies,
“By the time the Fed actually does seriously start reversing course, people will wonder what took them so long,” he said. “I do not think that is the environment that we are in right now.”
The Fed spent the last three to four years supporting the economy, and investors should not assume the central bank “is really that stupid” to let it fall apart, Bernstein said. “They may not be the smartest guys in the world, but they are not that stupid.”
Is there value abroad?
GMO’s forecast for emerging market equities is a real return of 6.2% over the next seven years, but Montier cautioned investors against embracing that asset class.