(Philip Straehl, Morningstar Managed Portfolios) Looking ahead, the supportive environment is evolving quickly, and all eyes appear to be on inflation at the moment. Supply shortages in cars, furniture, and appliances coupled with strong consumer demand have created near-term inflation pressures. As long-term investors, we attempt to look through short-term noise and buy assets that offer the most attractive reward for risk while constructing portfolios that are robust to different economic environments. The run-up in risk assets has made finding value more challenging. This is reflected in the positioning of our multi-asset portfolios:
- We are slightly cautious in our broader risk assessment, taking a modestly protective stance, acknowledging the strong run up in markets and some fundamental risks ahead. We continue to like some cyclical areas of the market, but we are offsetting some of our cyclical risk with exposure to defensive sectors such as consumer staples and a minor equity underweight, overall, based on our valuation work.
- In equities, we have broadened our value-oriented holdings with key positions in energy and financial companies, which makes sense to us for most economic pathways. That said, exposure to value stocks remains among the largest relative driver of our portfolios at the current time. In our multi-asset portfolios, we carry a non-U.S. equity overweight, too. This includes exposure to Japan, the U.K., and emerging markets.
- For portfolios with healthy fixed income exposure, we favor emerging-market debt in local currency and retain some inflation protection, although we have trimmed the latter position as inflation expectations increased recently. Elsewhere, our analysis still shows that many fixed income markets are expensive, especially so in high yield bonds, where we have shifted to an underweight position. In fixed income, we are balancing defensive characteristics against low absolute yields. We are also using alternative assets exposure to deal with the risk in fixed income at this yield level.
- Our underlying currency positioning depends on the portfolio in question. For more conservative portfolios, we are overweight the dollar. As we get into portfolios with more equity, we carry less dollar exposure (partially explained by our preference for non-U.S. equities) alongside a range of currency exposures, including the Japanese Yen, which tends to behave as a safe haven currency in periods of broad market stress. Broadly, we continue to lean on the protective characteristics of the dollar where it makes sense to do so and have recently boosted this exposure.
U.S. Equities Outlook - Low to Medium Conviction
Looking ahead, we see two offsetting developments. On one hand, the strength of the recovery is leading to fundamental improvements with corporate profits continuing to rise. On the other hand, we must recognize that much of the recent rally was sentimental optimism, with valuation concerns festering.
Taken together, at current prices, U.S. equities still look expensive overall, according to our analysis, both in absolute terms and relative to international markets.
However, there are pockets where we continue to see opportunity. One issue we face is that these opportunities tend to cluster in more cyclical (or economically sensitive) areas of the market—including energy and financials, which have both done exceptionally well recently. Despite recent strength, we continue to believe integrated energy companies with diversified business models and strong balance sheets provide significant potential upside for investors. Our research also leads us to believe that large U.S. banks are still relatively attractive, even as we’ve downgraded the sector to Medium. Lower-than-expected loan losses and a potential acceleration of loan growth as we enter 2022 provide a favorable medium-term backdrop for the sector.
Outside of these sector opportunities, we do share concern regarding the overconcentration to “new economy” stocks in the broad index, with FAANGM—Facebook, Amazon, Apple, Netflix, Google (Alphabet) and Microsoft—now making up over 24% of the S&P 5001. We don’t assess these stocks with a broad brush, but the extreme popularity in this space is creating valuation challenges.
Overall, the backdrop warrants continued caution towards U.S. stocks.
Europe ex.-U.K. Equities- Medium Conviction
European stocks continue to do well and have enjoyed a strong period, buoyed by a successful vaccine program and the reopening of economies. This has helped lift European corporates, many of which had long suffered from sluggish revenue growth. Inflation concerns are also less of an issue here, at least in perception, supporting prices.
We tend to find opportunities in Europe when we dig into country and sector differentials. For example, German stocks remain an appealing area in our analysis, offering solid balance sheets and upside to earnings—without the eyewatering valuations in some other markets.
At a sector level, our positive view on European integrated energy companies has moderated following exceptional performance, although it continues to rank well on a relative basis.
U.K. Equities - Medium to High Conviction
The United Kingdom has a relatively large exposure to energy and financial stocks, which has supported the market in recent times. This follows an extended period of underperformance, as the economy slowly turns the corner from the issues it faced during Brexit. This is also supported by local developments, with the successful vaccine rollout and the reopening of the economy ahead of most country peers.
We have tempered our view following recent market strength yet still believe investors are being well-compensated for the risk of investing in U.K. stocks. Granted, certain scenarios continue to pose risks to corporate profitability, but U.K. corporates remain high-quality businesses with diverse revenue sources in aggregate (the majority of revenue is derived elsewhere, diversifying the revenue drivers).
Japan Equities - Medium Conviction
We continue to see merit in Japanese holdings. For the most part, our conviction in Japanese stocks was built on some major structural change taking place at a corporate level. While some of this structural tailwind is now behind us, we still see scope for a continuation of improving shareholder interests, rising dividend payouts, and board independence. Japanese stocks also carry some diversifying properties that may help if we encounter a downturn.
Therefore, Japanese equities are still among our preferred major equity markets. With this in mind, we maintain a preference for domestic-facing companies, most notably financials. Sentiment toward Japanese financials has also been hindered by the Bank of Japan’s prolonged quantitative-easing program, which has driven down longer-term yields, making it difficult for banks to make money (and lowering investment income for insurers).
Emerging-Markets Equities - Medium Conviction
Emerging-markets stocks have had a difficult run, with meaningful losses in some markets. Part of the reason these stocks have lagged is influenced by Chinese regulatory headwinds, with some of the largest companies under the microscope and weighed down by heavy fines. This is especially true among the Chinese technology giants, which have meaningfully underperformed the market.
However, inflation is also a major challenge across the board, triggering a general rate hiking cycle in many emerging markets and causing nervousness among emerging market investors.
We consider emerging-markets equities, despite recent moves, to be among our preferred equity regions (alongside U.K., European, and Japanese equities), with EM Europe standing out.
China now offers better absolute and relative value than before the sell-off, even with allowance for the impact of announcements and potential further shocks. Therefore, the case for adding exposure to China is building, albeit from a low base. Sector opportunities also exist, with technology now offering a reasonable reward for risk—especially relative to U.S. peers.
As part of this, we need to remember that emerging markets are heterogeneous. Investors tend to bucket emerging markets as one, but often the real opportunities present themselves at a country, sector, or regional level.
Global Sectors
At a sector level, we continue to see significant dispersion, although the leadership has changed meaningfully as economies have reopened. Perhaps the most notable are energy stocks, which are significantly outpacing other sectors, albeit from a low base following a decade of underperformance. At the other end, utilities have underperformed, which is perhaps not surprising giving the “bond proxy” nature and the potential unwinding of monetary stimulus.
Let’s start with energy stocks, given their extraordinary run. A lot of people are still cautious about the outlook for the energy sector, but this is potentially to their detriment. First, the bad news. The sector obviously faces some long-term structural questions as the world moves away from fossil fuels, meaning returns are unlikely to come in a straight line. The good news? The global energy sector has survived its darkest days, which saw a negative oil price at one point. Additionally, the longer-term transition towards cleaner energy remains broadly on track despite some concerns about the profitability of clean energy. This development is particularly interesting when we consider climate-change risk, with European energy companies making a meaningful pivot towards renewables.
Elsewhere, our analysis suggests that financial companies offer attractive relative valuations versus the broader equity market, particularly in the U.S. market. For banks, we believe risks are skewed to the upside in the next year or two, driven by fundamental improvements that include solid economic growth, low loan losses, and a higher capital return.
Developed-Markets Sovereign
- U.S. and Australia - Low to Medium Conviction
- Europe and UK - Low Conviction
- Japan - Medium Conviction
The real story here is all about inflation and whether it is transitory or structural. This is a major point of contention among bond investors, creating heightened volatility in this space.
More recently, we’ve seen inflation concerns rising. This has led to central-bank discussions around rate hikes and/or unwinding stimulus, with knock-on effects to bond yields. Taken together, this has resulted in losses for developed-market treasuries.
Locally and globally, this remains an uninspiring space, although government bonds have seen some major change and continue to play a role in a total portfolio context.
We acknowledge that central-bank intervention is always an issue for this asset class, as central banks have the power to manipulate government-bond yields to entice spending and reduce the interest burden of governments.
Of note, we still assign U.S. Treasuries with a Low to Medium conviction level. This acknowledges the Federal Reserve’s commitment to supporting and steadying the bond market, with a slow and measured tapering of the unprecedented amounts of Treasury bond purchases planned and a keen eye on inflation developments.
Investment-Grade Credit
- U.S., Europe, and UK - Low to Medium Conviction
Corporate bonds have stuttered, running out of steam following a period of strength. That said, investment-grade corporates continue to have easy access to borrowings at historically low rates. Bond investors also still seem relatively unfazed by corporate vulnerabilities, with borrowing costs remaining quite low relative to government bonds (credit spreads remain tight, despite a small unwinding).
Both locally and globally, we still expect low returns over the long run. A key element to our conviction is that corporate spreads (the difference between corporate-bond yields and government-bond yields) remain below fair value in our analysis. This provides less margin for error and opens the door to a greater permanent loss of capital if credit downgrades were to occur.
In this regard, one should be aware of the high percentage of BBB-rated issuers (the lowest level still considered investment-grade) in this space. This credit-quality development needs to be monitored carefully, as a heightened default cycle can’t be ruled out, either.
From a fundamental standpoint, the Federal Reserve’s increased involvement in this asset class has provided a backstop, although withdrawal of that support, increasing leverage ratios, and the possibility of higher yields are a cause for concern over the medium to long term.
In summary, we don’t see much inherent appeal for investors in the investment-grade space. We see some remaining attraction as a middle ground—providing some extra yield versus government bonds and a duration profile that could help in portfolio construction.
High-Yield Credit - Low to Medium Conviction
High-yield credit has experienced a wild ride in recent years. However, investors are likely to be satisfied given the circumstances, with liquidity moving freely and central-bank support allowing it to be one of the best performers in the bond universe.
We note this type of volatility isn’t unusual for high-yield bonds, which sit at the riskier end of the bond universe—sometimes moving with equity markets. This has certainly been the case since the onset of COVID-19, with high-yield-bond prices seesawing in line with broader equity market sentiment.
The case for investing in this asset class has deteriorated meaningfully. While headline default risks are seemingly low, overvaluation risks loom ever larger, and our conviction reflects these risks.
Emerging-Markets Bonds
- Local Currency - Medium to High Conviction
- Hard Currency - Low to Medium Conviction
Emerging-market bonds have struggled, although they have held up better than their equity counterparts. That said, we’ve seen losses in both local-currency debt and hard-currency debt, as some central banks are forced to raise interest rates to heed inflation risks.
Together, nominal yield levels remain near historically low levels, albeit much higher than developed-world peers. Emerging-market debt in local currency (which we prefer over hard currency) continues to offer healthy relative yields, even accounting for risk. Our view remains that emerging-markets sovereign fundamentals are broadly stronger than in the past (improved current account balances, enhanced reserves, movement to orthodox monetary policy, build-out of local investor base allowing for a shift to local currency funding) with some ongoing concerns surrounding an increase in debt levels and a lack of fiscal discipline in some countries. In addition, an aggregated view of emerging market currencies also looks undervalued and should be a tailwind over time.
The area can be volatile, yet even allowing for some pessimistic assumptions, our research suggests that investors could earn a decent premium over similar-duration U.S. Treasuries if they’re willing to risk short-term loss. Said differently, we think investors are likely to be compensated for this risk over time, especially for local-currency bonds.
U.S Agency MBS - Low to Medium Conviction
The mortgage market has recovered strongly following the sharp dislocations as market liquidity dried up in the COVID-19 pandemic. The Federal Reserve acted swiftly to ensure proper functioning of the mortgage securities market, and this backing helped drive the spread between U.S. Treasury and mortgage-backed securities (MBS) yields to very tight levels.
Like most fixed-income asset classes, MBS have low nominal yields by historical standards, posing a challenge to future returns. In addition, the nature of the asset class means they could underperform comparable Treasuries in a rising-rate environment, as borrowers stop refinancing and take longer to pay off their mortgages.
We also expect a tapering of the Federal Reserve’s ongoing purchases in the space as part of the journey through economic recovery towards higher rates. This tapering should happen simultaneously for both their MBS and Treasury purchases, but it has the potential to see spreads increase from very tight levels. Overall, this has somewhat reduced our conviction.
Global Inflation-Linked Bonds - Low to Medium Conviction
As near-term inflation rises beyond central-bank long-term targets and previous expectations, it is unsurprising that inflation-linked bonds have done well. This is exacerbated by continuing supply bottlenecks and an economic recovery as we emerge from COVID lockdowns.
A key consideration in a multi-asset context is whether inflation-linked bonds can help us diversify our risk drivers. Keep in mind that with inflation-linked bonds, the value of the principal rises (or falls) with changes in inflation expectations. Inflation expectations are notoriously difficult to forecast, so this is a key benefit.
With that, inflation-linked bonds can behave differently though the cycle, offering diversification in risk drivers in certain scenarios. One important consideration is duration risk, where inflation-linked bonds are often longer-dated securities, which increases interest-rate sensitivity. This can at times undermine the benefits from the inflation protection.
The market is starting to price in meaningfully higher inflation rates over the next five to 10 years. U.S. Treasury Inflation-Protected Securities continue to offer protection against an inflation shock, but increasingly at prices that have already adjusted with the recent pressures we have seen.
U.S. Municipal Bonds - Low to Medium Conviction
The asset class has experienced meaningful improvement as investor flows turned positive and liquidity challenges eased along with support from the Federal Reserve, though lower-quality credits took longer to recover lost ground.
Yields on high-quality municipal bonds have fallen meaningfully; given the relatively low level of yields, we continue to expect municipal bonds’ absolute after-tax returns to be subdued but perhaps higher than the after-tax returns from other U.S. fixed-income investment-grade bonds.
We also expect some fundamental deterioration, as state and local governments are likely to be negatively impacted by the COVID-19-induced economic downturn; moreover, uncertainty around additional fiscal aid leaves room for volatility, and lack of further support may challenge their recovery. It’s worth noting, however, that municipalities’ balance sheets had generally improved going into this period, putting the asset class in a relatively sound position to weather a storm.
Global Infrastructure - Low to Medium Conviction
- U.S. Energy Infra & MLPs - Medium to High Conviction
Energy-related investments were under pressure prior to the COVID-19 pandemic, and that pressure increased dramatically when the pandemic sapped demand and caused oil prices to crumble. While the path to demand recovery was uncertain, valuations became very attractive under most scenarios.
Since those lows, energy has made a strong recovery, supported by a higher oil price.
While oil prices are significantly higher than the 2020 lows and energy-infrastructure equity prices have rebounded strongly, we continue to believe the sector trades at a discount to the overall U.S. equity market.
We think the high dividends will entice investors back into the sector as U.S. production stabilizes and demand continues to recover. We believe that this downturn will put pressure on management teams to further improve governance and capital-allocation discipline. Specifically, our expectation is for a meaningful reduction in capital expenditures by energy infrastructure companies on growth projects, with overall spend being reduced towards maintenance, or “steady-state” levels. Headwinds remain amid the Biden administration’s push to address climate change, but the transition to renewable energy is likely to be a long path, potentially allowing for an extended period of robust free-cash-flow generation for the industry—which we anticipate will be used to strengthen balance sheets and return cash to shareholders.
Listed Property - Low to Medium
While moves to reopen global economies are progressing, we believe that earnings risks remain elevated in the short term. Elsewhere, investors in office REITs face a more depressed rental-growth outlook over the short term and an uncertain outlook over the medium to long term. Time will tell if the trends toward accelerating online sales and working-from-home persists. However, from a valuation perspective, global listed property assets are beginning to price in little room for error in this recovery, and we continue to see superior opportunities elsewhere.
Alternatives
Alternatives have delivered mixed results since the pandemic, although they are broadly positive, perhaps shadowed by the strong returns from equity markets.
With low bond yields and a difficult forward-looking landscape for equities, alternative assets can appeal, given that returns from this asset class have a lower direct relationship with the performance of traditional asset classes such as equities and bonds. Investment selection remains critical, however, with our preference for genuinely diversifying assets with a focus on reasonable cost and liquidity.
Currency
While currencies are notoriously volatile, we tend to think of currency positioning via the lens of portfolio robustness (targeting defensive characteristics where sensible) but also as a potential source of return at extremes.
At this level, we aren’t seeing any extreme currency moves in the major markets, although some emerging markets have seen significant moves. More broadly, exposure to the Japanese Yen and the British Pound continues to appeal, although our conviction to the latter has diminished in more recent times. In aggregate, we maintain select exposure to foreign currencies, all things being equal, and subject to individual portfolio objectives, with the Japanese yen in particular expected to provide diversification qualities and help preserve capital in times of market stress.
Cash
We currently have a balanced view regarding cash levels. On one hand, the economic vulnerabilities are worth protecting against, but our research points to some meaningful dispersion across asset classes, which presents an opportunity for investors. The key is to selectively allocate to the most attractive asset classes rather than take widespread market-cap exposure.
More pointedly, we see our cash reserves serving three purposes. First, cash helps reduce the sensitivity to interest-rate rises, especially relative to long-dated bonds, which we believe is an important risk to manage. Second, cash should help buffer the portfolio from any future volatility resulting from a fall in equity markets. And third, cash provides us with ample liquidity to take advantage of investment opportunities as they arise.
