Sticking with sectors that now look entrenched in a post-pandemic world can help investors navigate the new storm of rising rates, inflation and geopolitical uncertainty. Greg Wilensky, Head of US Fixed Income, and Jeremiah Buckley, portfolio manager, explain why.
- The pandemic induced structural changes could represent attractive long-term opportunities as opposed to assets whose volatility is currently at the mercy of factors beyond our control.
- Consumer spending is expected to be supported by lockdown accumulated savings although consumer preferences are likely to differ to their pre-pandemic habits.
- Conservatism is called for in credit although financials may present a long-term, healthy reposition.
- Markets continue to walk a tightrope of a challenging macro backdrop, rising commodity prices and disrupted supply chains, all of which underscores the benefit of flexible asset allocation.
It is difficult to imagine a return to a pre-pandemic way of working, living and consuming. The structural shifts in societies and economies have been rapid and far-reaching, with relentless trends such as digitalisation and decarbonisation driving change.
As 2021 drew to a close, investors were already adjusting weightings towards certain sectors and assets to ‘life after COVID-19’. Since then, the rapid escalation of uncertainty and volatility in 2022 at the hands of rollercoaster markets and geopolitical tension has made it more urgent than ever to identify stable and diversified sources of returns.
To achieve this, allocators can consider a different approach. Rather than focus on uncontrollable forces – from inflation and commodity prices, to interest rates and geopolitical tension – investors may want to identify a suitable combination of equity and fixed income exposures with long-term return potential.
This boils down to strategies focused on identifying companies with the potential to capitalise on a long-term secular story, fuelled by attractive and differentiated products and services that create and provide value to their customers.
We believe that a balanced approach could offer the highest possibility of creating growth over many years, instead of trying to pre-empt or predict the unpredictable.
A multi-layered equities approach
Currently, we believe long-term themes anchored by the pandemic look set to drive economic growth for the foreseeable future. Among these themes are advanced technologies, where we have seen a significant shift of technology applications to the cloud, coupled with a transition to both software and infrastructure as a service.
Changing consumer preferences is another theme to watch. New habits create new demand, and customers that have become e-commerce advocates will unlikely return to their old ways. In turn, this should continue to have a positive impact on payment spending.
More broadly, the consumer discretionary sector has the potential to rebound. While it has been one of the worst performing sectors early in 2022 due to rising inflation in basic goods and commodities, and geopolitical uncertainty, valuations for the highest quality long-term growth companies now appear attractive.
Added to this, consumer spending is expected to prove resilient. A solid recovery in employment, and therefore wage growth, in addition to a generally large pool of savings accumulated during the pandemic, may further help this sector weather the storm on consumer confidence.
Those investors who map their equities portfolios to such evolving trends have the potential to benefit from reduced volatility without compromising returns due to exposure to proven businesses that can generate strong cashflows and take advantage of market downturns to improve their market positions.
In line with this, industries like energy and financials pose potential risks longer term amid their struggle with core volume and organic growth, combined with macro headwinds.
De-risking in debt
COVID-19 has also had a notable impact on fixed income. For example, post-pandemic spread compression made compensation for credit exposure less attractive coming into the year, despite positive fundamentals. Though spreads widened in the first quarter, we believe it is prudent for investors to bolster government exposure while reducing overall credit risk.
Known risks are one thing, perhaps of bigger concern is the impact of the unknown risks. Unfortunately, these are mounting; nobody could have predicted the Ukraine invasion. And the Russia/Ukraine conflict has complicated the US Federal Reserve’s (Fed’s) already difficult task of navigating a soft landing for the US economy.
We believe these risks call for a more conservative approach to spread product. High quality securitised assets backed by residential mortgages are one area that may be appealing. In terms of corporate credit, while there are still attractive opportunities in the higher rating segments of the below-investment grade space, or BB-rated bonds – based on expectations that a significant amount of these “rising star” companies may potentially become investment grade through 2023 – the uncertain backdrop suggests a shift up in quality may be prudent.
Looking at sectors over the longer term, financials – especially banks – currently appear attractive too. Spreads have widened relative to other sectors of the corporate market, and with a healthy amount of issuance, repositioning becomes possible.
Further, the fact that banks are constrained in the activities they can pursue to drive growth should appeal to bond investors since this limits their credit risk.
Walking a tightrope
More broadly, against the challenging macro backdrop and assumptions of a protracted Ukraine conflict, we believe issues with supply chains and high commodity prices have the potential to continue to blight market performance.
This underscores the benefit of having flexibility to adjust asset allocation over time by weighing the risks and opportunities in different asset classes depending on market conditions. To do this effectively requires integration between teams, constant communication and dynamic adjustments to each allocation in the portfolio as well as the overall mix between equities and fixed income.
This is rooted in allocations that ensure diversification, both across fixed income instruments as well as finding a balance between stocks whose businesses are stable across multiple economic scenarios and more cyclical companies that can benefit from periods of economic recovery when they arrive.
Asset allocation: The allocation of a portfolio according to an asset class, sector, geographical region, or type of security.
Credit rating: A score assigned to a borrower, based on their creditworthiness. It may apply to a government or company, or to one of their individual debts or financial obligations. An entity issuing investment-grade bonds would typically have a higher credit rating than one issuing high-yield bonds. The rating is usually given by credit rating agencies, such as Standard & Poor’s or Fitch, which use standardised scores such as ‘AAA’ (a high credit rating) or ‘B-’ (a low credit rating). Moody's, another well-known credit rating agency, uses a slightly different format with Aaa (a high credit rating) and B3 (a low credit rating).
Cyclical stocks: Companies that sell discretionary consumer items, such as cars, or industries highly sensitive to changes in the economy, such as miners. The prices of equities and bonds issued by cyclical companies tend to be strongly affected by ups and downs in the overall economy, when compared to non-cyclical companies.
Diversification: A way of spreading risk by mixing different types of assets/asset classes in a portfolio. It is based on the assumption that the prices of the different assets will behave differently in a given scenario. Assets with low correlation should provide the most diversification.
Investment grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings when compared with bonds thought to have a higher risk of default, such as high-yield bonds.
Spread/ credit spread: The difference in the yield of a corporate bond over that of an equivalent government bond.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. It is used as a measure of the riskiness of an investment