Global Perspectives: PCS Team offers shock therapy for market turmoil
In this edition of our Global Perspectives podcast series, the Portfolio Construction and Strategy (PCS) Team discusses key insights from their latest Trends and Opportunities report, entitled “Shock Therapy.” Global Head of PCS Adam Hetts moderates the conversation with two of the team's Senior Portfolio Strategists, Lara Castleton and Sabrina Denis.
30 minute listen
- A trifecta of severe shocks – decade-high inflation, extreme interest rate volatility, and slowing growth – has left few places for investors to hide in 2022.
- The sell-off in both stocks and bonds has led some to question whether the diversification benefits of the 60/40 portfolio are still intact. We don’t think the 60/40 is dead, but we do think it needs some changes.
- While we acknowledge the pain that has been felt this year, we also recognize that the current period comes at the end of a decade-plus of exceptional market strength. We believe investors should view the current landscape as a blank slate and seek to take advantage of new opportunities.
Actively managed portfolios may fail to produce the intended results. No investment strategy can ensure a profit or eliminate the risk of loss.
Alternative investments include, but are not limited to, commodities, real estate, currencies, hedging strategies, futures, structured products, and other securities intended to be less correlated to the market. They are typically subject to increased risk and are not suitable for all investors.
Commodities (such as oil, metals and agricultural products) and commodity-linked securities are subject to greater volatility and risk and may not be appropriate for all investors. Commodities are speculative and may be affected by factors including market movements, economic and political developments, supply and demand disruptions, weather, disease and embargoes.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Environmental, Social and Governance (ESG) or sustainable investing considers factors beyond traditional financial analysis. This may limit available investments and cause performance and exposures to differ from, and potentially be more concentrated in certain areas than, the broader market.
Emerging market investments have historically been subject to significant gains and/or losses. As such, returns may be subject to volatility.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.
Growth stocks are subject to increased risk of loss and price volatility and may not realize their perceived growth potential.
Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.
U.S. Treasury securities are direct debt obligations issued by the U.S. Government. With government bonds, the investor is a creditor of the government. Treasury Bills and U.S. Government Bonds are guaranteed by the full faith and credit of the United States government, are generally considered to be free of credit risk and typically carry lower yields than other securities.
Mortgage-backed securities (MBS) may be more sensitive to interest rate changes. They are subject to extension risk, where borrowers extend the duration of their mortgages as interest rates rise, and prepayment risk, where borrowers pay off their mortgages earlier as interest rates fall. These risks may reduce returns.
Value stocks can continue to be undervalued by the market for long periods of time and may not appreciate to the extent expected.
Beta measures the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.
Bloomberg U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.
Correlation measures the degree to which two variables move in relation to each other. A value of 1.0 implies movement in parallel, -1.0 implies movement in opposite directions, and 0.0 implies no relationship.
Credit Spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.
Credit quality ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).
Dividend Yield is the weighted average dividend yield of the securities in the portfolio (including cash). The number is not intended to demonstrate income earned or distributions made by the portfolio.
Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
MSCI World Index℠ reflects the equity market performance of global developed markets.
Quantitative Tightening (QT) is a government monetary policy occasionally used to decrease the money supply by either selling government securities or letting them mature and removing them from its cash balances.
Volatility measures risk using the dispersion of returns for a given investment./p>
Adam Hetts: Welcome to a special edition of Global Perspectives. I’m your host, Adam Hetts, Global Head of Portfolio Construction and Strategy, or PCS as we call it here at Janus Henderson. And for all of you that know and love our PCS team and our insights and maybe consultations, then you know it’s not because of me, but it’s because of the team. So I’m excited for this episode where I get to interview two of my team members. We’ve got Lara Castleton and Sabrina Denis, both Senior Portfolio Strategists. Lara and Sabrina, welcome to the show.
Lara Castleton: Hi.
Sabrina Denis: Hi, thank you for having us.
Hetts: So we’ve got Lara here in Denver with me, and we’ve got Sabrina in London, so truly global perspectives that we’re bringing you today. So at the risk of stating the obvious, here at the PCS team, our daily job is working with Janus Henderson clients. We deliver customized portfolio analytics. And more importantly, we bring that data to life with our insights on not just your portfolio, but on the thousands of other client portfolios we have in our database. And we also publish those insights for broader consumption, and that’s the topic for today. PCS Trends and Opportunities is our flagship publication, with the September edition just hitting the shelves. So this is our outlook, and as you’ll see in the conversation today, it’s not just based on forecasts, but it’s really made to help you digest the confusing macro environment into actionable portfolio solutions. So if you haven’t seen the latest edition of Trends and Opportunities, please check out the links in the show notes. But let’s go ahead and get into it. Lara, we’ll start with you. So, this edition is titled “Shock Therapy.” Can you explain why we went with the title “Shock Therapy” this year?
Castleton: So shock seems to accurately encapsulate the sentiments we are hearing from clients everywhere. And really, it’s because 2022 has just been a trifecta of pretty severe shocks. So we’ve seen decade-high inflation, extreme interest rate volatility, and now slowing growth, and all of these have just really left few places for investors to hide. So as you mentioned, we’re not forecasters. We can’t predict when these risks will subside, but we can put into context kind of where we’re at. So since 1939, every time the S&P has crossed the 20% loss threshold into bear market territory, which we clearly have done, markets did have further downside. However, inclusive of that downside, you’d on average have a positive gain of 15% over the next 12 months. So this really highlights what our team has been preaching throughout this challenging year, it’s, “Let’s think longer term, let’s stay the course, stay invested.” The point of writing this is not to erase the pain that we have felt, but it is really to understand where we can go from here.
Hetts: Thanks, Lara. I think that a 20% drop in the subsequent returns on average is kind of a good indicator of some of the silver lining out there. And for those ex-U.S. listeners, if you check out the publication, we have some similar statistics on the MSCI World that kind of runs parallel to the results that Lara just mentioned. So then speaking of shocks, Sabrina, one of the biggest shocks has been, for 60/40 investors this year, having historically huge losses. So one of the biggest headlines and the biggest questions we get from clients is, “Is the 60/40 dead?” So what do you think about that question at this point, Sabrina?
Denis: So that’s been a controversial question that’s actually been asked by many, many clients this year, simply because everyone, all investors globally, have been challenged with declining bond and equity returns at the same time. And by the way, this hasn’t happened very often in history, actually only three or four times since 1928, really depending on the data you look at. So this is a very unusual year, with the usual type of worries and emotions, though, so, if they should sell if the market drops or start to buy in when they feel it’s really coming up, and so on. And even though returns have been painful this year for both asset classes, we wanted our clients to see this year’s volatility relative to the other years in the market. So if you look at 40, 50 years of history again, a double-digit decline in the 60/40 portfolio is not uncommon, for example. And history really shows us that investors who are patient, who withstand the emotional rollercoaster – and I know that’s not easy at all – and who stayed invested during corrections were often rewarded with a rebound within the 12 months following a bear market.
Hetts: That’s great, Sabrina. So I think history points to staying invested, but staying invested doesn’t mean staying still. So let’s go ahead and now break down the 60 and the 40 into what we think is most important going forward in the equity and the fixed income portion of typical portfolios. So we’ll start with the 60, or the equities, and, Lara, back to you. What’s top of mind for you in equity allocations right now?
Castleton: One of the biggest questions that I’m now getting during my consultations is, “When do I want to get back into growth?” So I think that’s an overly simplistic question, but I understand the premise behind it because there have been certain areas of the equity market this year that have sold off obviously much more than others. So there’s more growth-oriented technology, communication services sectors, they have had much more pain versus, let’s say, energy or utilities, which have held up a little bit better. So, understandably, investors I think are now wondering if we’ve hit this max punishment in growth-leaning sectors and if it’s time to rebalance for the bounce. So again, I’m going to go out on a limb and say, I’m not good, our team is not good at predicting exactly when the bottom for these tech and growth-oriented sectors will be, but we do tend to agree that a lot of pain has been felt, and it might be time to start thinking about rebalancing portfolios. So what I would rather clients focus on, though, is that this market recovery is probably going to look a lot different than the previous decade, so it can plausibly include much different leadership than what we’ve experienced. And so while I’m not good at market timing, I do feel relatively confident in the fact that we won’t see zero percent interest rates, sub-two-percent inflation any time soon. And so we’re just facing a different market environment where those superficial categories like growth, value, cyclical defensive, etc., they just may have lost some relevance. So when we’re looking at equities, our solution right now to positioning for that recovery would be to focus on quality. I know that’s a word that’s been thrown around a lot, but we’ve created this kind of cute acronym around it to make it more tangible, which is MOAT. It’s our way of providing a framework for equity investing among the three biggest challenges that we’re facing today. So, MOAT, “M” stands for margins, “O” for ownership, “A” for advantages, “T” for tenacity. Let me just briefly explain a little bit of each of them more in detail. What really have been thus far the two most present challenges this year? It’s been inflation and rate volatility. So for these two particular risks, it’s critical to narrow in on companies’ balance sheets. “M,” margins, companies that have wider margins allow the company to have better pricing power in a higher inflationary regimen. “T,” which stands for tenacity, it’s aimed at the structure of the debt on the company’s balance sheet, so lower leverage and/or longer-term financing allows for tenacity – ability to hold up better amidst higher rates. Now, what are we facing potentially? It’s the slowing growth environment perhaps becoming a little bit more pronounced. So whether rapidly or at a more level pace, we do want to prepare for that. “O,” ownership, good management teams that are nimble. And “A,” advantages, so companies that have a competitive advantage, durable growth opportunities, these are qualities that can help a company to better navigate that slowing growth downturn. So we’ve seen that companies exhibiting these four qualities, they’ve actually been able to do better in a selloff. And I think it’s a really important way to frame up how to position your portfolio for a market recovery.
Denis: And, Lara, speaking of recovery, as you mentioned before, for example, technology stocks have really struggled this year after leading the market for, I think, a decade, and having been one of the most popular sectors in the last couple of years. Even though the last year has been tough, technology retains a critical role, and we think also a deflationary power for the future of our society, as it will continue to make processors faster, better, and cheaper. Just thinking about all the technology that goes into electric cars, digital payments, and now it’s a part of our everyday life. I think during COVID, 20 times more people have been using Zoom for their daily meetings than, for example, a year before in 2019. So there’s no question that tech is a key sector out there, but we believe that it’s all about quality and, in this case, quality growth. Technology is really a highly fragmented market. There’s still lots of unprofitable or highly leveraged companies, and they still make up a significant proportion of the index. So that’s why we think that the solution for clients, look for the opportunities and do their due diligence on what’s attractive out there to reestablish our allocation to tech right now. And by that, I really mean higher quality, more profitable firms that are able to reinvest their profits into research and development of new products, which will then help them to gain market share from those companies that struggle and are less profitable.
Castleton: One other thing I want to talk about, too, is we’ve talked a lot, Sabrina and I, already, in equities, about focusing on positioning for this recovering market. A lot of clients that we talk to still do want to maintain this core defensive posture within their equities. And so, for that, I do think there’s an opportunity to turn to the international developed space of the market. And the reason that we say that is because actually allocating outside of the U.S., in particular, that international developed space, there’s a greater prevalence of more cyclical value-oriented sectors, those that have historically done better with higher rates, higher inflation. And within that universe of more cyclical value-oriented sectors comes just more exposure to companies that have the ability to generate strong and growing dividends. Actually, if you’ve looked at the constitution of real returns for stocks going all the way back to 1970, in all regions across the globe – so, real return meaning what’s the return of components subtracting inflation out from that number – the majority of return comes from dividend yield and dividend growth. So it’s hugely important in this type of a market where we have high inflation, we are facing slowing growth potentially, that cash generation can really help be that ballast of financial professional portfolios. So these fundamentals we think are really strictly helpful as we face an uncertain path ahead. And in fact, if you looked historically, higher-yielding stocks do perform better in a market downturn.
Hetts: Thanks, that was great. That’s a relatively brief summary of what is the global equity landscape. So, I like those concepts: sort of quality as this profound lens to look at global equities and even technology, given the nature of the slowdown we’re experiencing. And then just thinking about the mechanics of equities globally, you have the U.S. and EM, more growth-oriented regions, and then as Lara just pointed out, ex-U.S. developed need a little more value, cyclically oriented as a complement to work alongside the U.S. and EM or growth-oriented regions. So that’s a good tour of the 60, the equity piece. So moving on then to the 40 of the 60/40, the fixed income piece. So, Lara, I’ll stick with you. So what’s most important to you in fixed income right now?
Castleton: Fixed income has been painful. Most people have been extremely frustrated with fixed income this year. It has been a rather unprecedented sell-off across all sectors. I’m going to start first outside of the core of fixed income, so more higher yielding opportunities for bonds, there are attractive discounts with the sell-off that we’ve experienced. There are, however, still numerous amounts of risks that we’re facing. There’s still interest rate volatility we could potentially see, and then there is the slowing growth environment that we’re entering into. When we think about slowing growth environment and fixed income outside the core, sectors like bank loans, and high yield, and convertibles, and preferreds, all of those serve the purpose of getting yield; however, they do have more of this correlation to equities, they do have the potential to sell off with equities. So in a slowing growth environment, we just need to be smart in terms of how we approach a fixed income allocation right now. High yield is a sector, for example, that historically has been in portfolios to generate income. Right now, with the fundamentals of where we’re seeing high yield spreads at the moment, they’re currently at about 482. Historically, going back to 2000, if we were to look at the average peak of high-year spreads – and we’re taking out COVID, we’re taking out 2008, because those were pretty extreme levels – even with that, if we looked at average peaks of high yield spreads going back to 2000, those were at 830 basis points. So if we’re at 482, the potential for spread widening in high yield is pretty great. So as we’re facing a slowing growth environment, the single-sector benchmark-constrained allocations we think potentially introduce too many risks. So our solution for fixed income, particularly outside of the core, is to go with a diversified approach. Most of the clients that we work with allocate to the multi-sector bond category because of the flexibility to, one, be able to allocate to multiple sectors, not just one. And then, more importantly, to just be able to pivot as the market is changing so rapidly, they can overweight one sector when it looks attractive and then quickly pivot to a more attractive level as spreads potentially blow out in high yield, for example.
Hetts: So Sabrina, any thoughts on fixed income that you want to add?
Denis: No, I think I totally agree with Lara that any kind of strategy at the moment that gives investors flexibility during these uncertain times, possible or potentially recessionary times, right now really deserves a place in clients’ portfolios. There’s a wide spectrum of these alternative strategies out there, because often investors are staying away because of their complexity or because they don’t really know where these alternatives fit in their asset allocation. And I’m not just speaking about fixed income alternatives; obviously with those you can even benefit from the interest rate volatility you see in the market because they are benchmark unconstrained. As Lara mentioned, you have to have flexibility to adjust the credit and duration exposure accordingly, as much as these fixed-income alternatives, but also more broadly – equity-like ones, or multi-strat[egy], they usually provide different risk and return exposures, so really what the clients want at the moment. Uncorrelated returns usually have a lower beta to traditional asset classes, so in a nutshell, really, that is what we would call alternatives. But to be successful with these alternatives, it’s really important to follow a clear intention and be really up front on the role that they should play in a client’s portfolio. And then I think they are really a great tool, especially, as I said, in the uncertain time right now that we’re seeing.
Hetts: So when you’re talking about these alternatives, Sabrina, the unconstrained, nontraditional, lower beta, lower correlation strategies … can you give some examples of these types of strategies that you’re seeing in client portfolios?
Denis: Especially here in the UK, I would say we’re seeing a lot of client portfolios now holding more and more absolute return funds, but also funds that, we would say, fall into the category of multi-strategy. So, in between fixed income and equity alternatives that really cover a really broad range, and usually, they also often include a couple of different strategies. For example, hedge funds, commodities, anything kind of like global macro, etc., so everything that’s uncorrelated in the current environment is very, very popular at the moment with our UK clients and in their portfolios.
Hetts: So we’ve covered the 60/40 I think pretty well. It’s not dead. It needs some changes. And I think the concepts we talked about with the equities and fixed income are pretty universal or global in nature, but in a global team, we still have different regional focuses that are driven by different regional clients with different needs. So Sabrina, sticking with you, can you talk about just the EMEA region and what you’re seeing that you think we haven’t talked about so far that maybe has become a bigger focus for you locally than what you’ve seen in the U.S.?
Denis: Yes, so on top of the ongoing volatility in the global markets, as you said, Europe is just struggling on top with an energy shortage, which has just been triggered by the post-sanctions following Russia’s invasion of Ukraine in February this year. So these shortages, along with our global economy coming out of COVID, cause a rapid increase in inflation. And obviously, I’m really speaking about double-digit numbers that have seen last in the 1980s. At the same time, we really face a moral dilemma here, as on one side we aim to move towards greater sustainable energy production, achieving and reaching the net zero goals out there, while on the other side we’re also just trying simply to keep the lights on as our gas prices soar. So we’ve had many clients asking us this year if this whole trend into ESG strategies that we’ve seen in 2020 and 2021 is already over. That’s a very legitimate and topical question as well, but that’s always why we thought one of the themes for our EMEA Trends and Opportunities piece is sustainable investing, and not only how investors can tackle all the problems around greenwashing, and the inconsistent and backward-looking ESG ratings, but also how to be positioned in terms of the energy transition in the future. And we definitely think that sustainability has evolved over the past couple of years, but this year clients really did challenge what sustainability actually means for them, so that’s really a bit different. And, of course, the ESG space is still maturing and will remain over the next couple of years a diverse space, and there’s no off-the-shelf ESG solution available for any investor. But as a team, we really believe that any tailor-made active solution in ESG, and investors who are using their proprietary tools and research, coupled with the right expertise, are really essential when clients are trying to build successful sustainable portfolios. That’s really a big trend here in Europe.
Hetts: I’m glad you brought up sustainability. So I think obviously very important for the ex-U.S. listeners, even for U.S. listeners, that are starting to focus more on ESG. I think the global perspective we have as a team has been helpful because what’s happening outside of the U.S. has sort of been a preview of where the trends in the U.S. are heading for sustainability. So if you’re a U.S. investor or listener that feels like you’re a bit ahead of the curve on sustainability, I think you can check out some of our ex-U.S. publications we’re getting in the queue of where the trend is going ahead of the U.S. there. So then speaking of regional trends, Lara, anything else you want to point out that’s in the U.S. edition of our Trends and Opportunities, that’s not in the EMEA edition?
Castleton: Yeah, I talked about fixed income a little bit, but I’d like to take the conversation back to fixed income and more along that core portion of fixed income portfolios when we talk about the U.S. Within that core space, we think Treasuries, agency mortgage-backed securities, and investment grade credit as the three dominant sectors for that U.S. aggregate index. We see one of the trends is into that agency mortgage-backed market. The reason being, it has sold off actually more than Treasuries and investment-grade credit because of what we’ve seen with mortgage rates skyrocketing this year. The benchmark is primarily comprised of the lower coupon mortgages – two, two and a half, for example. And with mortgages now sitting north of 5, 6 percent even, then that active opportunity set should be concentrated in higher coupons, because with those lower two and two-and-a-halfs, there’s potentially a little more volatility as the Fed enters into QT [quantitative tightening]. So it’s a great opportunity to get defensiveness in a fixed income portfolio, but we just think that an eye needs to be placed towards actively navigating the space.
Hetts: That’s a great update. I think that really covers asset allocation implications in what’s been a crazy year, all of which, again, is summarized in our Trends and Opportunities publication. So, then I guess looking forward, Lara, I’ll stick with you for one more question. What’s next? What’s on the radar?
Castleton: So I just think it’s important to level set really where we’re at today. And I really take it with three approaches. One is just to recognize the strong markets that we’ve had leading up to 2022. In fact, in the three years leading up to 2022, so since 2019, the S&P has more than doubled, and that is most likely not what most people were expecting from normal capital market assumptions. So we have been blessed with really strong markets, really over the past 10-plus years. Two, though, we do need to recognize the pain that has been felt this year, so it has been hard to find anything that’s worked in portfolios, it has been a very difficult environment, and we absolutely recognize that. But three, it’s, now let’s try to take that blank slate approach. The sell-off that we experienced is offering a lot of opportunities going forward. How can we proceed? And these trends are hopefully ways that clients can think about, wise ways to invest going forward.
Hetts: So Sabrina, how about you? What are you focused on right now?
Denis: Actually, we’re kind of working on a couple of interesting pieces in the team. One is a deeper dive into the quality MOAT framework that Lara mentioned earlier, and another Trends and Opportunities piece that we’re solely focused on sustainability. So really a great one as we’re going to go deeper into the challenges, but also the opportunities of sustainable portfolio construction. So we will also have a couple of examples of how investors actively can invest in sustainable trends such as responsible resources, or sustainable credit. So keep an eye out for any future publications from our team. I think it’s definitely worth it.
Hetts: Well, a big thanks to Lara and Sabrina – obviously, the brains behind the operation here on the PCS team. If you like this conversation, you can read as a follow-up, with the link in the show notes, our Trends and Opportunities publication entitled, “Shock Therapy,” this edition. That publication, as always, is alongside other insights from Janus Henderson. If you’d like to read more, please check out our website, and please like and subscribe anywhere you listen for more global perspectives. And we’ll see you next time. Thanks for listening.