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Finding the right asset mix for long-term investment goals is challenging in the best of times. Today, the dilemmas are even more daunting. In conversations with clients, we're hearing recurring questions about diversification that require innovative solutions for unusual market conditions.
In early 2021, investors have become increasingly upbeat about the world's path to recovery from the pandemic. But ironically, this optimism has fuelled market trends that add uncertainty to the outlook. Bond yields remain extremely low, but a shift may be beginning. Stock market valuations—particularly in the US—look relatively high. Mounting expectations of accelerated economic growth are tempered by distinct country-specific experiences and policies. Massive fiscal stimulus could resurrect inflation, yet investors are rusty at addressing this long-dormant risk.
Against this backdrop, we're hearing one underlying question from clients: How do you meet target premiums with persistent low yields and elevated valuations? While there's no one-size-fits-all answer, three principles can help point the way. First, think critically about how the recovery will unfold and don't be seduced by simplistic headlines. Second, check that your exposures offer diverse sources of return—both within and across asset classes—for changing conditions. Third, strike a balance between capturing diverse sources of return potential and securing adequate protection against complex risks, even if this exacts a short-term performance cost in some cases.
1. Prepare for a Bumpy Three-Phase Recovery
Every investment planning discussion today must begin with an assessment of the pandemic exit path and its macroeconomic implications. While much is still unknown, we project a three-phased recovery, each presenting investment challenges given the opaque outlook.
In early 2021, Phase 1 of the pandemic recovery began to unfold. COVID-19 vaccination programs began to gain momentum around the world, though some countries are far behind and many experienced new peak infection and mortality rates that began to retreat in February. These developments present a conundrum for investors seeking signs of economic improvement as governments struggle to balance reopening efforts against fears of a virus relapse.
By late February, we started to see the first signs of Phase 2. Efforts to contain the pandemic began to succeed at reducing the spread of coronavirus in the US, Europe and Asia. This raised hopes that economic activity could soon reopen—albeit at a "new normal" level—and consumers would unleash pent-up spending. By midyear, we believe many companies will report strong recoveries in earnings growth, especially given the low level of comparable profits in 2020.
Yet the road to a sustainable recovery won't be smooth. By 2022, after the initial sharp rebound, companies are unlikely to post such rapid growth. And as the world begins to normalize during this third post-COVID phase, we're likely to find that economic growth faces the same hurdles—and likely the same risks—that prevailed before the pandemic.
Through all three recovery phases, investors should brace for periodic market turbulence. Indeed, in late February, US Treasury yields jumped, prompting market volatility as investors began to digest the implications of rising interest rates on different types of assets. But with a solid conceptual framework, it should be easier for investors to calibrate exposures to realistic market expectations and to maintain firm strategic allocation plans through uncertainty.
Where Will Interest Rates Go?
Interest rate expectations underpin any investing outlook today. Record low rates have become a persistent source of uncertainty for investors, with central banks pledging to maintain extremely loose monetary policy to support COVID-stricken economies.
For bond investors, low yields make it harder to find income while raising concerns about the efficacy of sovereign bonds as a tool for risk reduction. Equity investors have seen low rates provide powerful fuel for growth stocks, while suppressing multiples for value stocks. These trends complicate diversification efforts within asset classes and between them.
Clients often ask us where we think interest rates will go through our three-phased recovery outlook. While global economic growth is expected to accelerate in the second half of the year, we don't think interest rates will rise dramatically anytime soon. Since the recovery is very fragile, policymakers aren't likely to let rates rise too far, too fast—even if inflation begins to materialize. Yields in most markets will probably stay low through 2021.
In the US, our economists forecast the 10-year US Treasury yield to reach 1.75% at year-end, from about 1.60% in mid-March. That's below the level that prevailed before COVID-19, yet a 21% leap from the March 1 rate of 1.45%. Massive fiscal stimulus should help the US grow faster than other developed economies, prompting a faster increase in rates from 2022 than in the euro area and Japan, where rates are unlikely to turn positive. In all three regions, real yields were still negative by the end of January (Display).
2. Broadening Sources of Return
With yields so low, fixed-income investors need to find diverse sources of better return potential. Looking for global credit opportunities that offer different types of exposure to economic recovery can help investors benefit from yield disparities across regions and sectors.
Countries' bond returns differ greatly from year to year because of varying economic cycles, monetary cycles, business cycles, inflation regimes, geopolitical concerns and yield curves. Returns also vary by sector within countries and regions. Retailers in the US aren't exactly like retailers in Japan, for instance. The result of all this variety is a compelling risk/return profile and strong defensive characteristics.
In a world with over US$17 trillion of negative-yielding debt, pockets of the global corporate credit market stand out as a sizeable, investable group of assets offering attractive levels of yield. Fundamentals are broadly supportive, companies have taken advantage of low rates to strengthen their liquidity buffers, and supply and demand conditions are very favorable. The key is to be selective.
For a healthy yield pickup over investment-grade corporate bonds, fixed-income investors can tap US securitized assets, whose underlying cash flows come from different sources than credit. This sector has performed well during periods when Treasury yields rose. In particular, we believe credit risk-transfer (CRT) securities—residential mortgage-backed bonds issued by US government-sponsored enterprises—are especially attractive. CRTs enjoy strong fundamentals, thanks to resilient demand in the US housing market.
Financials are another sector that should benefit from an economic recovery and rising rates. In Europe,subordinated bank debt is especially attractive, in our view. Yields on Additional Tier 1 bonds (AT1s) of European banks exceed those of European and US high-yield issuers in other sectors, while their balance sheets have been bolstered by improving capital and liquidity ratios.
We also expect emerging-market debt to be buoyed by the weaker US dollar, continued fiscal stimulus, attractive valuations and strong investor demand for income in a low-yield environment.
For investors willing to sacrifice liquidity, private credit is becoming an increasingly popular way to complement and diversify public credit exposure. Yet many institutional investors are still underexposed to private credit, which offers return streams that are uncorrelated with other asset classes plus the added benefit of an illiquidity premium. Private credit can provide access to pre-crisis return potential driven by transactions with much lower risk profiles than in the past. And since private loans are usually based on floating rate notes, we believe the asset class should do well in a rising rate environment, too.
What do these diverse sectors have in common? They should all benefit in different ways if vaccine rollouts continue, economies reopen and growth rebounds, prompting a tightening of credit spreads. Most fixed income sectors have delivered strong returns since US Treasury yields started to rise last summer, because these rising rates are accompanied by expectations of better growth as the economy reopens.
Revisiting the Growth-Value Equities Gulf
Equity investors also face diversification challenges that have been fomented by the low rate environment. In particular, growth stocks have outperformed strongly through the pandemic, led by a small group of dominant US-based mega-cap giants and high-flying companies with supercharged sales. Value stocks, meanwhile, have suffered a decade of underperformance.
Low rates are generally good for all stocks but especially for growth. That's because a stock's value is determined by the present value of its future cash flows. And since cash flows of growth companies are typically generated much further in the future than value companies, a decline in the discount rate benefits growth stocks disproportionately. Conversely, a higher discount rate is generally more favorable to value-oriented companies, which have nearer-term cash flows and earnings streams.
That helps explain why value stocks rallied during the fourth quarter of 2020 and again in early 2021. Vaccine successes in November fueled optimism for an accelerated economic recovery that could prompt a rise in rates. And value stocks are more heavily represented in cyclically sensitive sectors such as industrials, materials and financials, that tend to benefit from rising economic growth. In the first two months of 2021, the MSCI World Value Index advanced by 3.9% in local currency terms, while the MSCI World Growth Index slipped by 0.2%. In the US, the Russell 1000 Value Index rose 5.1%, while the Russell 1000 Growth Index fell by 0.8% over the same period.
Our research suggests that the gulf between value- and growth-stock performance in recent years has been driven primarily by multiple expansion. Over the last six years, growth stocks outperformed value by 92%. Of that, 82% of the difference is explained by multiple expansion and only 10% by the combined effect of earnings growth and dividends. At the end of February, global value stocks trade at an unprecedented 51% price/forward earnings discount versus growth stocks (Display).
This sets the stage for a potentially big style rotation toward value, with the exit from the pandemic serving as the catalyst. As the world recovers from COVID-19, economic growth could broaden and become less volatile, while visibility into the economic outlook and post-pandemic behavior improves. Asset allocators may rebalance into value after years of outflows. These trends would all help boost value multiples. As interest rates begin to normalize, growth multiples may narrow. Meanwhile, tighter regulatory scrutiny of some growth giants could reduce their earnings and multiples.
Does that mean investors should pile in headfirst to value stocks? Of course not. However, for investors who have avoided or reduced value holdings in recent years, we think the time is right to initiate or add exposure to what could potentially be a powerful source of returns in a recovery.
That doesn't mean growth stocks are doomed if rates rise. Investors should check that their growth allocations aren't overly exposed to the most expensive names, which could retreat sharply in a style rotation. Growth portfolios focused on stocks with resilient business models to support consistent earnings growth and profitability through the recovery should be capable of delivering sustainable long-term returns, even if some of the hypergrowth and momentum winners of the last year recede. Pay special attention to valuation and to overheated pockets of the market.
3. How to Control Equity Risk?
Some of those hot market segments started to cool down during the first quarter of 2021. As they did, fresh volatility in late February also elicited questions about how to reduce equity risk in an allocation. Do government bonds still help offset equity risk at today's low yields? And are there effective diversifiers within equities to help control volatility?
Last year's coronavirus sell-off provides important insight on the role of government bonds in an allocation. In fact, government bonds were one of the few true offsets to equity market volatility when stocks crashed in February-March 2020 and again during the pullback in September.
On days when US stocks fell in 2020, the correlation between US Treasuries and the S&P 500 (Display, left) remained below -0.4. And in Europe, yields on 10-year German Bunds were well into negative territory when stock markets fell in March and September. But correlations between Bunds and the MSCI Europe Index (Display, right) became even more negative during those sell-offs, falling to around -0.5. In other words, government bonds became more defensive when defensiveness was needed most.
Correlations can be unstable. Over the last three decades, the inverse correlation between stocks and bonds has broken down several times. Most recently, in early March, rising US Treasury yields (and falling bond prices) prompted weakness in equities, resulting in a very low positive correlation between the markets. Historically, though, these episodes have been brief and the correlation has always returned to negative territory.
In the near term, we expect occasional blips of the correlation between Treasuries and stocks into low positive territory, thanks to supportive central banks and a periodic repricing of bond yields as the economy recovers. But over the longer term—and particularly during risk-off events—we believe negative correlations will prevail and government bonds should provide an essential anchor to windward.
That's why investors shouldn't react to the prospect of rising rates by eliminating duration from their fixed income portfolios. A healthy allocation to diverse sources of credit allows investors to participate on the upside when risk assets rally, but duration provides a cushion against credit-related losses, as well as equity downturns.
Within equities, too, investors can find good ways to combat volatility in allocations. For example, consider traditional defensive stocks, which are usually prized for stable businesses and cash flows that can help reduce risk but underperformed sharply through the pandemic in 2020.
As a result, relative valuations of defensive sectors such as healthcare and consumer staples are much lower than sectors such as technology and industrials (Display). While rising rates are usually a headwind for defensive stocks, we believe attractive valuations of high-quality stocks create different starting conditions today. Strong balance sheets and businesses with high cash flows should position companies well for an array of risks and provide sources of solid long-term return potential while cushioning allocations from volatility.
Time to Talk About Inflation
While market shocks in 2020 were fast and violent, the inflationary effect on markets is more of a creeping risk. Many investors are rightly seeking advice now on how to prepare.
Our economists don't expect a sustained inflationary burst anytime soon. However, with massive stimulus funds sloshing around the global economy and expectations of a pickup in GDP growth, it's time to dust off the playbook for inflation—with adjustments for the post-pandemic environment.
Several investment options deserve consideration. In fixed-income portfolios, moderately reducing duration can be an effective hedge against inflationary risk. Similarly, securitized credit—such as credit risk-transfer securities—provides solid defenses against inflation while still capturing return potential and yield. But beware of Treasury Inflation-Protected Securities (TIPS) and similar inflation-linked bonds in Europe and other regions. In many cases, the real yields on these bonds today are negative, so they are unlikely to help provide a return lift amid inflationary drag.
In equities, the recovery of value stocks discussed earlier could be catalyzed by inflation. But beyond the growth-value divide, investors should make inflation risk a high priority when scrutinizing new and existing holdings. Company business models and margins should be tested for their ability to absorb potential price rises for inputs and passing through rising prices to customers.
This may also warrant a new look at companies in sectors that can benefit from inflation, such as commodities and financials. All equity portfolios—core, growth or value—must demonstrate that their allocations at the stock and sector level reflect a proactive position for inflationary changes. Beyond equities and fixed income, investors may also want to consider commodities, real estate and other real assets that could serve as an inflationary hedge.
Emerging markets (EM) may also offer benefits in an inflationary environment. Many EM countries produce commodities, whose prices would be expected to rise in an inflationary world, adding another impetus for faster growing developing economies.
Proactive Positioning for a Post-Pandemic World
While every investor is different, following clear principles can help inform strategic planning for a variety of long-term goals. With a coherent set of guidelines about how the recovery path is creating new opportunities and risks, we believe investors can capture diverse sources of return in stocks and bonds of companies that are set to emerge stronger from the pandemic.
Though it may sound cliché, a historic crisis can create conditions for an equally historic recovery. But given the risks and uncertainties, you can't be passive about how the future will unfold. Proactive investing approaches are the best way to make sure that portfolios are positioned to reap diverse sources of return in a post-pandemic world while protecting allocations from volatility both within and across asset classes.
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Christopher Hogbin is Head of Equities at AllianceBernstein (AB). Scott DiMaggio is Co-Head of Fixed Income at AB.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of all AB portfolio-management teams, and are subject to revision over time.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.
