The key questions we were asking during much of 2020 about the impact of COVID-19 and the associated restrictions have now been largely answered. The much debated “shape of the recovery” has been more V than W (or U or L-shaped, or indeed any other shape); the business environment has been successfully supported by stimulus measures such as JobKeeper; and multiple effective vaccines have been created, tested and rolled out in record time.
Of course, there is still a long way to go before we get back to something resembling ‘normal’, not least achieving a significant level of vaccination amongst the broader population. The economic and social impacts are still playing out and hold some uncertainties and potential concerns.
But from an investment perspective, it’s been a much more positive story, particularly in areas such as equities and credit, commodities, and Australian residential property.
The driver of this has been stimulus and liquidity which together have driven the economic recovery and, at the same time, pushed asset prices ever higher during the last months of 2020 and this has continued into 2021.
However this performance is unlikely to be repeated, even if liquidity continues to be pumped into the economy through monetary policy, and despite the positive economic outlook.
In our view, the most likely outlook is that economic growth will continue at a steady rate but at a slower pace than experienced in recent months. While the overall investment backdrop will remain constructive, market returns though will moderate. This reflects the fact that starting points are already elevated as recovery and low interest rates have been priced. Ongoing growth without persistent inflation will help, but the big gains are behind us.
The main reasons for this include:
By almost any metric, most stock markets are now fully valued. There is still some upside potential (particularly in value stocks and outside the US) but the strong run in most markets leaves little room for further valuation expansion.
In addition, we would also assert that one of the main arguments for higher valuations – that there is a large gap between earnings yields and bond yields – is no longer as relevant as it was.
Likewise, we believe that there is not much more left in credit. Spreads are already significantly compressed, and there is an increasing likelihood that interest rates will rise from here.
Both the Reserve Bank of Australia and other central banks have shown a strong commitment to maintaining low interest rates and supporting the economy. However there continue to be question marks about how long they can maintain this stance, particularly as economic data remains positive.
With increasing concerns about inflation, any hint of a persistent rise in inflation could provide significant headwinds.
For investors, this means there is a balancing act ahead, of positioning themselves to continue benefiting from the recovery but being prepared for a more challenging environment.
This means repositioning portfolios to adapt to a low interest rate, low yield world. We have been doing this in our multi-asset strategies, shifting out of very low, or no, yielding asset classes into those that offer more return. This doesn’t mean going “all in” on equities albeit a core of good quality equities is still important, but broadening investments in those assets that offer decent yields without the volatility of equity markets.
Examples of this include targeted corporate bond exposures, including developed market high yield debt and Asian corporate bonds, insurance linked securities and segments of the private debt market including both direct loans to corporates where additional premiums are on offer and in direct real estate lending for investment, construction and development purposes. Many of these opportunities offer diversity and yield without the same risks as equities. We also think that with interest rates constrained by central banks, currency markets will bear some of the burden to manage growth and inflation rebalancing and will offer opportunities for investors.
Multi-pronged asset class opportunities
Overall, we believe the key for investors over the short-to-medium term will be to take a multi-pronged approach, looking within core asset classes for opportunities, expanding the investment universe into private markets where premiums can be earned, and ensuring appropriate tactical asset allocation will combine to deliver targeted outcomes for investors.
By taking such an approach, it’s possible to be in a position to take advantage of any opportunities arise in an ever-changing market, while at the same time achieving protection from the risks that will also emerge.
Simon Doyle, head of fixed income and multi-asset, Schroders