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Asset allocation – Dealing with ‘lower for longer’

Blog, Coronavirus

Daniel MORRIS
 

The unprecedented crisis caused by COVID-19 has left asset allocators disorientated. Uncertainty has deepened and the outlook now is for bond and equity returns to be lower for even longer, making the hunt for yield all the more acute for investors. In their latest longer-term asset allocation update, senior investment strategist Daniel Morris and Koye Somefun, head of multi-asset & solutions in the Quant Research Group, present their views on what to expect after the great pandemic of 2020. Here are their main takeaways.

A new era of lower for longer

In the current environment, equities remain one of the few asset classes offering growth potential. First, though, a look at bond markets and inflation.

With global GDP set to fall sharply in 2020 and nearly USD 5 trillion in stimulus announced, debt-to-GDP ratios are bound to rise. However, central banks are likely to buy a significant share of the new debt.

Despite policymakers’ efforts to protect jobs and businesses, we do not expect a V-shaped recovery. This recession will leave deep, lasting scars. Disinflationary pressures and central bank actions are likely to keep bond yields low in the near term, giving a new lease of life to the lower-for-longer mantra.

Taking the lead, the US Federal Reserve (Fed) is likely to keep rates at zero for several years. Its medium-term objective for real yields is clear: drive them low and keep them there.

Inflation likely to feel conflicting forces

The short-term impact on US consumer inflation from the COVID-19 crisis is likely to be negative. We expect the slump in demand to cause inflation to fall.

In the longer term, as demand recovers, we could conceivably see the economy push up against capacity constraints. Concerns over interwoven supply chains in an age of pandemics and great-power rivalries could reverse globalisation, limiting competition and lifting inflation further.

We doubt, however, that these trends will overcome the disinflationary forces exerted by further automation, even greater use of technology and internet-driven price transparency.

What is the outlook for equities?

As they exit the crisis, companies are generally likely to face weak demand. Companies already under operational stresses will feel more pressure in the coming months. Consequently, the default cycle will be longer.

Consensus estimates now reflect a rosy US earnings recovery. However, the US market appears much more expensive than the rest of the world. Much of the premium is in ‘broad’ technology: internet retail, movies and entertainment, and interactive media industries. These sectors should continue to benefit from changes in consumer and worker behaviour. We expect tech multiples to compress, though that may well happen simply by earnings rising rather than by mean reversion.

As for emerging markets, investors have become much more aware of the risks. There is one consolation: countries are in a better position today than before the Asian financial crisis. However, the ability to repay debt has declined as country – and corporate – revenues have dropped along with falls in GDP, trade, tourism and oil prices.

Emerging market equity valuations are among the most attractive of the main regions. This may reflect the significant challenges many countries face (as highlighted above).

China’s outperformance underscores a key advantage: rapid government and central bank intervention. Furthermore, the Chinese market has a high share of tech companies that stand to benefit over the long term from post-coronavirus trends.

Overall, valuations are broadly reasonable, with markets in some countries seemingly good value and some sectors with higher multiples able to offer even better long-term growth potential than before the crisis.

A closer look at returns

What do higher debt levels and slower growth mean for longer-term returns? Since our predictions are based on valuation models that can give insights into which assets were dislocated the most in the COVID-19-triggered sell-off earlier this year, we believe they can be helpful for investors who want to position themselves for a recovery.

Modest economic growth and loose monetary policy should lead to only modestly higher government bond yields in the next five to seven years: yields are forecast to rise by around 0.9% for the eurozone and the UK; by around 1.1% for core euro; and by around 0.7% for the US.

The Fed’s aggressively loose stance has had a major effect on the expected return of US cash and government bonds. With US rates likely to change little, expected returns are much more comparable to those of the eurozone than before the crisis. In addition, it has become much cheaper for eurozone investors to hedge US dollar risk.

In corporate bond markets, risk premiums on investment-grade credit are currently high compared with the long-term median. Corporate bonds will benefit if spreads contract to median levels over the coming year.

In excess return (and hedged return) terms, we have a marginal preference for UK and US over eurozone investment-grade credit.

For high-yield corporate bonds, we prefer the UK and the eurozone. US high-yield has a slightly lower rating quality and is therefore more sensitive to a heightened default risk in the current environment.

As for equity markets, we forecast an expected total USD return of 5.25% for the US. For Europe, we expect a total return of 4.75%. Japanese equities look cheap based on expected cyclically adjusted price-earnings.

Taking a portfolio perspective

  • We are comparatively positive on high-risk credit assets (emerging market hard currency, euro and US high-yield) and convertibles.
  • Choosing between equities and listed real estate, we prefer equities.
  • Within core assets, we favour equity and credit over government bonds.
  • We are more positive on inflation-linked government bonds than nominal bonds. We are most negative on the risk-adjusted return of US Treasuries.
  • Taking into account valuations, hedging cost, and the extent to which hedging can reduce portfolio risk, investors should hedge the exposure to most currencies, with the Japanese yen being a notable exception.

In summary, as we exit the crisis, the hunt for yield will intensify. Investors will again need to seek out equities, lower-rated investment-grade debt and emerging market bonds to meet their return targets, with all the risk that entails.


Also read: Longer-term asset allocation views: What to expect after the Great Pandemic of 2020

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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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