Multi Asset Boutique

Where does our investment compass needle point?

Viewpoint

After an incredible first quarter of 2020, we have experienced an almost equally incredible second one. Given the deep recession that was looming at its start, the strong and rapid recovery came as a surprise to many investors. Their new query: Are the markets too optimistic? We think: not for those who have a medium to longer-term investment horizon. When entering now, they can still access interesting return potential with many asset classes, according to our long-term return expectations, based on valuation ratios.

Where to find returns

Subscribing to the investor wisdom "Never fight the Fed" , within developed markets we prefer corporate over government bonds. We also like emerging market bonds as these offer even higher expected returns. Both these segments are now on the shopping list of central banks, which increases their attractiveness. In some emerging markets, reasonable levels of real yields reflect that central banks have greater room for manoeuver. This suggests higher potential for emerging market bonds in hard currency. For us, however, an active investment approach to country selection is essential.

Expected returns reflect the pandemic

In our white paper  "Six challenges for investors after Corona", we concluded that the pandemic would reduce expected equity returns. The pandemic will reinforce existing global trends that have been lowering global trend growth and expected equity returns in recent years. The trend towards de-globalization is gaining momentum, for example due to the plans of many countries to produce basic goods, such as protective masks and critical medicines within their own boarders. Historical studies show that in the wake of a pandemic, investment growth usually slows, which had negative consequences for growth and risky asset classes. Notwithstanding, since their trough reached in March, equity markets have already made up a lot of ground.

Nevertheless, in our view, developed and emerging market equities still offer attractive return potential. We expect technology stocks to benefit most from the structural adjustments arising in the wake of the pandemic. In addition, the technology sector appears to be more resilient than other sectors, as its companies usually have high-margin businesses, low debt levels, and high liquidity buffers. Even though the ongoing battle for digital supremacy  between the US and China could impede the exchange of information between companies and their business partners, we think such risk cannot uproot the digital revolution. This is why from a strategic standpoint, the technology sector looks promising to us.

Based on these assessments, we have updated our long-term return assumptions (chart 1; for details on the methodology, see also our study "Why long-term investing still pays off ").

2020-07-16_VP_what-to-buy-how-much-risk_chart1

The risk perspective

However, another investor wisdom still holds true: "If you want more returns, you have to take more risks". As shown in chart 1, equities offer significantly higher expected returns than other asset classes, but they also involve higher risk. Only high-yield corporate bonds and hard-currency emerging market bonds can keep up with expected return on equities at lesser risk. Currently, only government bonds involve significantly lower risk, but in many cases with negative expected return potential. Corporate bonds are an interesting alternative involving moderate additional risk.

What shifts to consider in investor portfolios?

In addition to the risk/return profile, the correlation of the individual asset classes is also decisive for portfolio optimization. Gold is exemplary to demonstrate this: While its risk/return characteristics are unattractive, gold is a strong portfolio diversifier. Historical analysis shows that, gold is the only asset that significantly enhances portfolio diversification, alongside currencies, such as the US dollar and, to a lesser extent, the Swiss franc. Therefore, gold is also justified in strategic asset allocation. However, the optimal asset allocation of a portfolio depends not only on the characteristics of the asset classes, but also on the investor’s individual risk capacity and tolerance.

Over the past six months, the corona crisis has led to a big shift across investor preferences. Some investors realized losses in spring, as their risk capacity declined. In contrast, risk tolerance has increased, as many investors are sticking to their return targets, willing to take higher risk to reach these regardless of existing geopolitical uncertainties, but (over)confident to huge liquidity supporting the financial system. Moreover, the attractiveness of asset classes has shifted too. For tactical asset allocation, we currently prefer the following ones:

LIKES RATIONALE
Equities Strong fiscal and monetary policy stimuli
High-yield bonds,
Hard-currency emerging market bonds
Significant expected return for relatively little additional risk
Gold Persistently low interest rate environment, higher longer-term inflation risk due to fiscal stimulus
DISLIKES  
Government bonds Low or negative yields, not compensating for higher longer-term inflation risk and fiscal expansion


What to consider during implementation?

To avoid companies that have suffered fundamental damages in the course of the Corona crisis, investors should prudently select developed and emerging market equities and bonds, based on thorough company analysis with a particular focus on the quality of business models and balance sheets. To minimize geopolitical risks involved, active portfolio allocation is key, particularly when investing in technology stocks. Moreover, considering economic, social and governmental (ESG) factors gains in importance in light of increasingly strict ESG regulation. Only an active investment approach can adapt to these changing conditions.

We believe that investors who tackle this right now may be better off at year-end than those who stay inactive, tempted by the summer break.

 

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