Written by: Jack Manley
The global economy appears to be in the early innings of recovery, while simultaneously staring down the limitations to growth in a pre-vaccine world. At this stage, it is worth revisiting asset allocation views. How should investors position themselves for immediate risks on the horizon and the expected recovery next year?
On fixed income, near-record low bond yields, stemming from coordinated global central bank policy easing, have combined with stress in credit markets to produce a challenging landscape. Investors have recently enjoyed some reprieve, with improving economic data and Federal Reserve support compressing credit spreads relative to their earlier highs. Default rates remain elevated, though, and recovery rates for high yield unusually low, meaning investors in lower-quality credit still may not be adequately compensated for associated risks. Opportunities may exist within this space, but investors must be careful to cut away exposure to energy and other challenged industries.
Given the macro risks and asset class challenges, portfolios should be generally underweight bonds and consider them primarily as an “insurance policy”. Quality is key, particularly in Treasuries, investment-grade corporates and high quality ABS and municipal debt; while a modest tilt toward duration could help hedge against equity market volatility. A domestic bias within fixed income is also still appropriate, though the argument has weakened with narrowing rate differentials and the nascent signs of fiscal unity in the EU.
Looking beyond the short-term and into the recovery and beyond, the story evolves: normalizing global rates increase the relative attractiveness of foreign debt. Domestically, long-end yields should rise alongside improving economic conditions through 2022, while short-end yields remain anchored at zero, steepening the yield curve, providing a more attractive yield environment and reducing the need for (and help from) duration.
On equities, we remain firmly overweight. Markets today have mostly recovered on the outperformance of a small handful of large-cap stocks and sectors that are well positioned to take advantage of post-COVID, pre-vaccine trends like telecommuting. Technology and “tech-adjacent” names (interactive digital media providers and e-commerce companies) have thrived, alongside health care and consumer staples. These sectors continue to be attractive, both due to their relative resiliency in earnings power this year and their reasonably high dividend yields, something increasingly important given the poor prognosis for bond yields.
At the same time, investors should consider partially rotating into cyclical parts of the market: financials, with “fortress” balance sheets and high borrower quality should weather this storm reasonably well; and consumer discretionary names, excluding those focused on travel, leisure and hospitality, should recover more swiftly than other beleaguered parts of the market. A full rotation into cyclicality would be a step too far, though: two of the more challenged sectors – energy and industrials – will likely remain so, with the same forces boosting technology utilization reducing demand for travel and energy products more broadly.
For the most part, these views are applicable post-recovery, as well: technology and health care are two powerful secular trends, and the proven viability of working from home means that reduced demand for energy products and travel may be more structural, at least for several years to come.
International assets have become more attractive, thanks to superior international management of the virus, narrowing rate differentials and a falling U.S. dollar. The more cyclical nature of foreign markets, particularly in Europe and Japan, should result in outperformance relative to the United States, especially in 2021 and beyond; investors can simultaneously take advantage of a valuation tailwind and an attractive dividend environment. The high growth opportunities found in emerging Asia remain attractive, with longer-term outperformance driven by a tilt toward manufacturing and the consumer, plus a rapidly emerging middle class.
U.S. assets should still make up the majority of a portfolio, though, given the long-term growth trajectory of technology and, given short-term risks, their status as traditional “safe havens” for global investors during periods of stress. Given time, though, this last consideration will fade.
On alternatives, we continue to see opportunities, provided risk tolerance and liquidity needs allow for them. The challenging yield environment is supportive of real estate and infrastructure investments, which offer an attractive income stream while having little correlation to equity markets. Potential for high volatility in the back half of the year is supportive of hedge funds, especially macro ones, which typically outperform in those market conditions; and inflationary concerns coming out of the recession, stemming from pent-up demand and fiscal stimulus, suggest a modest allocation to gold may be warranted.