The pandemic that defined 2020 may not yet be behind us, but the end is in sight. This year should be one of economic recovery as the rollout of vaccines allows global economies to reopen.
In this environment, we favour risky assets via equities, particularly in more cyclical markets outside of the United States. With its commodity exposure and higher dividend yield relative to other developed markets, we see Canada as especially well positioned in this environment.
We begin 2021 with a positive tilt towards risk through equities in our asset allocation, with a focus on more cyclical markets. We base this on our central thesis that vaccines will be deployed effectively and broadly enough to put the COVID-19 crisis behind us, allowing the economy to progress meaningfully toward recovery. Within equities, we have begun increasing our allocation to international markets, as we expect a rebound in global growth will support more cyclical and value names and help Europe, Japan and emerging markets outperform the U.S. We also believe some of the more structural drivers of U.S. outperformance are likely to be challenged over the next few years, and therefore it makes sense to diversify away from the U.S. and to a degree, from growth stocks in general.
In fixed income, we are allocating less to government bonds than in a traditional asset allocation, due to the expected economic recovery and currently unappealing low yields. As the recovery takes hold, we expect a steeper yield curve as longer dated yields rise, while central banks keep short rates low even as economic activity picks up.
Increasing economic activity would normally lead to tighter credit spreads, but returns are likely to be meagre given how tight spreads currently are. The dramatic fall in yields has also left benchmark index duration much higher than normal, exposing investors to large losses if yields were to rise. As such, the risk/return tradeoff looks poor. We are therefore focusing our investment-grade exposure on our global credit strategy, which is dynamic enough to manage these risks and still generate a reasonable return over time. We are also investing in riskier non-investment grade credit, which boasts sufficiently high yields to generate good returns in our base case and where we can lean on our in-house investment expertise to minimize default exposure. High yield also carries little duration risk and loans carry none at all, which further reduces our exposure to any rise in government bond yields.
One of the key challenges facing allocators in the current market is how to diversify a portfolio with bond yields at current levels. In the future, we intend to expand our capability set to include more diversifying strategies to address this challenge. For now, our solution is a barbell approach: adding risk in certain portfolios through equities and non-investment grade credit while simultaneously holding more cash than usual. The advantage of cash is that when markets experience volatility we will be able to buy assets at more attractive prices. In the meantime, cash provides a cushion for the riskier portfolio. We also think that duration in the U.S. and Canada can still provide some diversification, and we discuss this later on.
To generate additional return for clients who can tolerate illiquidity risk, we see value in some private market strategies that we believe have an attractive opportunity set right now and can generate high absolute returns over time. Given the ongoing recession, this could include particularly distressed or opportunistic private credit strategies.
The COVID-19 recession and recovery
Investors entered 2020 with considerable optimism. Late 2019 saw the presumptive end of the U.S./China trade war, the U.S. Federal Reserve had cut interest rates and made it clear policy would be more supportive going forward, and corporate earnings were growing again following a brief slump. This optimism led investors to take more risk, pushing positioning in and prices of risky assets like equities and credit to the highest levels we had seen for some time. When the impact of COVID-19 became apparent in early March, markets fell and the high level of positioning exacerbated the correction.
One important difference between this crisis and the Global Financial Crisis (GFC) is that in 2008 policy makers had to create new programs to respond to the unfolding crisis in markets. In March 2020, those programs were already in place and just needed activation. This is one reason the response from the Fed and other central banks was so swift and effective. By backstopping U.S. funding and credit markets, the Fed effectively eliminated the risk of a solvency crisis developing. They also activated swap lines with many foreign central banks that provided U.S. dollar liquidity directly to markets that needed it. The combination of this and massive, globally-coordinated fiscal stimulus stopped the economic contraction and led to one of the fastest market rebounds ever recorded.
One somewhat unusual aspect of this recession is cash balances of households and corporates have risen dramatically (Chart 1). This is partly because of support payments provided by governments, but also because people simply could not spend as much money as they normally would have due to COVID19 restrictions. This is not to say that all households have more money. As in the corporate sector, there have been winners and losers. Many firms and sectors have been unable to operate their businesses effectively due to COVID-19 and their employees have suffered, while other firms have thrived and their employees have kept their jobs and increased their savings. However, in aggregate, there appears to be meaningful excess saving globally and as the economy reopens and these savings are spent, corporate earnings and consumption growth should be very strong, while central banks are likely to remain highly supportive.
Chart 1: U.S. household and corporate cash
One key risk to this view is how structural this recession turns out to be. Recent recessions have been demand shocks, characterized by a fall in output across industries leading to underutilized productive capacity and a rise in unemployment. The policy response to this has been to increase deficit spending in order to replace some of the demand shortfall and prevent the waste of underutilized economic resources. Additionally, central banks have reduced the cost of borrowing and created forward guidance to inspire confidence, support markets and incentivize risk taking.
The demand shock from the COVID-19 recession has been uneven. Output has fallen sharply in industries like travel, tourism and bricks-and-mortar retail, but has risen in areas like logistics and the digital economy. However, lockdowns and other safety measures are a form of supply shock and global supply chains are far more complex than ever before. The Institute of Supply Management (ISM) found almost 75% of companies reported supply chain disruptions in February and March. Labour shortages resulted in manufacturing delays, creating shortages of finished goods. In commodities markets, production was scaled back, leading to shortages of lumber, cement and steel. We thus have an inflationary and deflationary shock hitting different parts of the economy simultaneously.
This creates a problem for policy makers. So far, their response has been focused on avoiding a wave of defaults by providing liquidity and loan guarantees, and offsetting demand loss through fiscal stimulus. However, stimulating demand when output cannot be quickly increased will simply raise prices. Ideally, as vaccines bring us close to herd immunity, lockdowns are removed and economic activity returns to normal. But as impressive as it is to have produced effective vaccines this quickly, there are many obstacles to actually vaccinating hundreds of millions of people around the world. The longer it takes before the virus is under control, the more likely we will end up with higher structural unemployment. This may also be highly uneven across countries, and given the aforementioned global nature of supply chains, may result in a kind of rolling supply shock.
Such a mix of weak output, stubbornly high unemployment and potentially higher prices is known as stagflation, a scenario for which there is no tried and tested policy response. Central banks are likely to look past rising prices caused by supply constraints, especially in the U.S. where this has been made explicit through the introduction of average inflation targeting. Fiscal stimulus could help if applied properly, but could also trigger inflation if applied too broadly. The advent of Modern Monetary Theory (MMT) raises an additional risk if it is pursued by governments, as the underlying assumption that increased fiscal deficits will not affect inflation likely doesn’t apply in a supply shock.
One possible scenario is the vaccine is deployed at different times and speeds across different countries. Given the global nature of most supply chains, and given a large share of goods production is concentrated in emerging economies, it is possible vaccines roll out faster and the recovery happens quicker in places with a larger share of global consumption, i.e., developed economies. This could lead to a rapid rise in demand, while supply is still constrained by ongoing lockdowns and virus safety measures, risking a larger than expected rise in prices. To be clear, we do not expect inflation to meaningfully exceed central bank targets next year, but this is a key risk to our base case so it bears monitoring.
Our base case is policy makers will be able to smooth out the journey to recovery, and while markets may be volatile, much of the current uncertainty will ultimately be priced out. However, we do recommend diversifying portfolios out of nominal assets and into real assets. We do this by increasing our equity allocation and allocating significantly to more cyclical markets like Canada and international markets. Part of their cyclicality comes from both direct and indirect commodity exposure. Commodity sectors as well as industrial commodities themselves are likely to do well, but they are also appealing as a hedge against the supply-shock risk described above.
Rotating out of growth stocks and the U.S. as growth returns
So how much is left to be priced in should our base-case for recovery come to pass? Chart 2 shows the performance from pre-COVID to now across a range of S&P500 subsectors. While the headline index performance is positive, it is important to note the dispersion of returns beneath the surface. It is this dispersion that shows how much COVID-19 uncertainty is still present. The chart reveals a huge gap between the performance of sectors directly hit by COVID-19 versus those that have benefited. It is logical to assume that a large amount of this relative performance is reversed as this uncertainty falls away, though it will likely not be completely reversed because many companies that have benefited have cemented their competitive advantage and will carry that forward. There may also be structural changes to the economy that hinder a full recovery for some companies and sectors. But broadly speaking, we expect positive but lower index level returns in the U.S. than we have been accustomed to over the last few years as this rotation occurs.
Chart 2: U.S. equity sector returns since December 2019
It is worth noting the dispersion of returns within U.S. credit markets is much smaller than in equities. This is especially true in high yield, where only transportation and energy show negative total returns since the end of 2019. Within investment grade, there is more dispersion than high yield, but still much less than equities. This likely reflects the Fed’s direct support for credit markets, which we expect to continue.
The rotation described above is also likely to have geographical implications and is part of the reason that within equities we have started to increase our allocation to international markets, where we see better return prospects going forward. The U.S. equity market has had a sensational run over the last 10 years, and it’s important to understand the drivers of this outperformance in order to assess the likelihood that it continues.
The main driver is strong U.S. earnings, particularly compared to non-U.S. earnings (Chart 3). Furthermore, this was a surprise relative to expectations. Over the last 10 years, realized earnings per share (EPS) have beaten consensus expectations more for the U.S. than international markets; consistently and by a wide margin.
Chart 3: U.S. and international EPS growth
The second driver has been the duration or discount rate effect, which has disproportionally helped growth stocks. Since the GFC, central banks have used monetary policy to lower the cost of borrowing and underwrite risk markets. This has pushed down discount rates and helped long duration assets produce very high returns. It’s important to understand this effect also extends to equities. More of the expected cashflow for growth stocks is further in the future than it is for more cyclical or value stocks.
This means growth stocks are more sensitive to changes in discount rates and therefore benefit much more from falling rates. This is likely also true for private equity, which has seen huge inflows of capital over the last 10 years and has also benefited from the tailwind of lower financing costs.
Ironically, a strong cyclical recovery would likely hurt growth stocks and growth-heavy markets like the U.S., precisely because of this duration effect and the fact that there is a very large overhang of positioning in these markets. We had a taste of this in November, when positive vaccine news prompted markets to start pricing in an economic recovery. As a result, yields rose sharply, value and cyclicals significantly outperformed growth and U.S. equities underperformed. This is actually quite common early in the cycle. Value has consistently outperformed growth in the early phase of economic expansions and underperformed in the latter phase (Chart 4).
Chart 4: Average cumulative return of U.S. value versus growth stocks over past U.S. economic expansions since 1953
One important question is whether this potential underperformance of the U.S. versus international markets will simply be the usual cyclical effect or whether it might be more structural. Our bias is it’s more likely to be cyclical. If our base case proves correct, then as the market prices in recovery, growth stocks should underperform, and this rotation away from growth should lead the U.S. market to lag its international peers. However, this will likely fade over time as the recovery progresses and we return to trend economic growth. To see growth stocks and thus the U.S. more persistently underperform would likely require a sustained period of upside surprises to global growth as well as a rise in trend global economic growth relative to the U.S., such as in 2003-2007.
To summarize, we believe that as we start to move past the COVID-19 crisis and the global economy recovers, long duration assets like longer-dated fixed income and growth stocks will underperform. Given the U.S. is much more exposed to the growth factor than its international counterparts, it’s likely to underperform too. However, we think this will only last for the early phase of this economic cycle.
What does this mean in practice? Historically, this early phase of outperformance for value and cyclical sectors has lasted between one and three years and has been worth between 10% and 40% of outperformance. We are reluctant to forecast a specific number, but suffice it to say we think we are only at the beginning of the recovery phase and we anticipate it will continue for some time and lead to significant outperformance of cyclical sectors and international markets.
On government bonds and diversification
Chart 5 shows the ratio of government bond returns to global equity returns during equity selloffs of more than 10% going back to 2007. For example, if global equities fall by 10% and bonds rally by 5% that would be a ratio of 0.5. You can see U.S. bonds returned somewhere around 30% of the equity correction consistently over that period. In March, during the equity selloff, U.S. Treasuries still returned6%, covering 20% of the total peak-to-trough selloff in global equities.
What is concerning is toward the end of the equity selloff, bond yields spiked, resulting in both Treasury and equity prices falling at the same time. Many commentators have argued this is a sign that at very low yields the hedging or diversification benefit of government bonds disappears. But we believe the selloff in Treasuries and other high-quality collateral was related to an unprecedented rise in demand for U.S. dollar cash to cover short-term funding needs rather than a sign U.S. government bonds can no longer help portfolios during large equity selloffs.
Chart 5: Government bonds still provide diversification unless yieldsfall below zero
This surge in U.S. dollar demand was spurred by investors unable to secure funding amid the losses in March 2020, and selling whatever they could to meet their commitments. Funding problems were particularly acute for emerging market countries with significant external financing needs. Countries like South Africa, Turkey, Brazil and others that rely heavily on U.S. dollar funding from foreign investors found themselves unable to cover their short-term liabilities, leading to fears of insolvency and further capital flight, which pulled their currencies down and made the funding problem worse. All of this led to a rise in correlations across assets as capital fled risky assets for the safety of dollars, which were in short supply.
The Fed responded by providing immense amounts of liquidity in various forms to the market, and ending the funding stress; and thus, the Treasury selloff. As vocally as market commentators refer to the selloff in Treasuries during the last stage of the equity correction, they should also note the 6% rally following the introduction of the Fed’s liquidity measures, during the equity rebound. In fact, if we consider the returns of equities and bonds over the entire first quarter, we find global equities produced a -23% return and U.S. Treasuries produced a +10% return, which would actually put the diversification benefit during this selloff close to the top of the list of previous selloffs in Chart 5.
Now we are not arguing that duration will reduce portfolio risk at all yield levels. Looking again at Chart 5, we can see that German Bunds, which had negative yields coming into the equity correction, produced negative returns. This is also true of Swiss, Japanese and other negative-yielding developed bond markets. German Bunds have in fact produced very little diversification benefit at all since their yields turned negative toward the end of 2016. However, at yield levels around where current U.S. and Canadian bonds are, they did produce returns in line with the longer term average during equity selloffs.
Our view is that low levels of yield impair future returns but do not necessarily impede the diversification arguments for owning duration, except at yields close to or below zero. As such, we allocate less than normal to U.S. and Canadian government bonds, not because of fears around diversification but because they hurt the chances of meeting our return targets.
Prospective returns are lower
Reducing our portfolio duration of course makes our portfolios riskier, in the sense they have less of a cushion in equity selloffs, i.e., expected portfolio drawdowns are higher. This is somewhat unavoidable, as there is a strong long-term link between starting valuations and future returns. The incredible performance of both equities and bonds over the last 10 years has pushed valuations to very high levels, hurting prospective long term returns. Chart 6 shows the S&P500 normalized earnings yield against subsequent 10-year total returns on the S&P500. The earnings yield might not tell you exactly what your future return will be, but it does a pretty good job of telling you whether it will be higher or lower than average. The other important point to note is that returns can deviate from this for some time, but eventually this has always been corrected. What you gained in the late 1990s you gave back in the 2000s. The point here is simply that current high valuations likely mean lower than average returns going forward.
This is even truer for fixed income. Your prospective returns on bonds are constrained by the starting yield. So, with the yield on 10-year Treasuries at 0.85% and the yield on investment-grade bonds at 1.8% you have to rely more on riskier assets like equities or non-investment grade credit to get you to average or above average returns in a multi-asset portfolio.
Chart 6: S&P 500 normalized earnings yield versus future total returns
The period since the end of the GFC in 2008 has seen very strong returns across markets. This was to a large degree engineered by policy makers, who responded to the crisis and the subsequent low level of economic growth and inflation by encouraging risk taking. Clearly, their intention was for this to take place in the real economy, but it instead took place in financial markets, pushing up prices and valuations. It has been an exceptional 10 years for anyone who owned financial assets, but the question now is to what extent it can continue.
Higher valuations have meant lower future returns, albeit with great uncertainty as to the path of those returns. At current valuations, especially in safer fixed income markets, we must allocate a higher weight to riskier asset classes to give us some chance of achieving above-average returns going forward. However, reducing our fixed income allocation increases portfolio risk.
Ultimately, all investors must recognize this and decide whether they are comfortable increasing risk to try to generate above average returns or whether they are more comfortable simply accepting lower returns. At Gluskin Sheff, we build portfolios depending on each client’s risk tolerance and their desired return level. In portfolios where clients have a higher risk tolerance we are tilting our allocations towards equities and non-investment grade credit, but we also hold more cash than normal to balance this higher risk and to give us the option of buying at better prices when we experience the next meaningful market correction. In more capital preservation-oriented portfolios with a lower risk tolerance we continue to allocate to government bonds and less risky fixed income, accepting lower returns going forward.
We believe we can achieve somewhat better returns allocating within equities to international markets, where valuations are more attractive, and also where there is a short-term catalyst for outperformance related to the economic recovery we expect in 2021. We also think it makes sense to diversify away from nominal assets and into real assets like commodities and commodity equities, which causes us to favour Canada and other international markets. These should benefit in our base case of economic recovery but would also provide a hedge in the scenario of higher inflation, should an uneven recovery from COVID19 lead to supply chain issues and an aggregate demand/supply imbalance.