"Inflation is unlikely to become a concern for markets any time soon."
Investment strategy 2021
Anchor: turn-for-yield
Where to turn for yield
The U-turn of the US Federal Reserve (Fed), from trying to normalize interest rates to guiding for zero rates for years to come, best illustrates the new policy paradigm that is relevant when devising investment strategies. What should investors consider? We take a look.
The forceful monetary policy reactions to the COVID-19 pandemic showed that, as long as inflation stays within central banks’ comfort zone, policymakers will do, in the famous words of former European Central Bank President Mario Draghi, “whatever it takes” to avoid a crisis. Thus, we think that the likelihood of an imminent crisis, due to either a deflationary threat or near-term overheating, has diminished significantly. As for risks of overheating in particular, inflation is unlikely to become a concern for markets any time soon, not least because the Fed, in its new policy framework, has signaled a greater tolerance when it comes to allowing inflation to overshoot. Policymakers in Western countries are likely to prefer such a scenario as it would, among other things, help them deal with rising public debt burdens.
All roads lead to equities
This policy setting suggests it is important for investors to ensure that portfolios have sufficient exposure to real assets. After all, high quality nominal assets promise only very meager – in most cases negative – real returns since central banks have pushed yields to low levels. With central banks continuing to look for ways to curtail risks, risk aversion and thus equity risk premia still have room to fall, which is likely to add to performance over the medium term. As economies stabilize further after the pandemic- related shock, investors looking to preserve real wealth and meet long-term obligations will be highly incentivized to invest a significant share of portfolios in equities.
Portfolio airbags
Low bond yields and falling yield volatility have created doubts about whether government bonds still provide an attractive means of diversifying large cyclical, i.e. equity-related risks in portfolios. Given the dire return outlook for bonds, should those bonds continue to play a role in multi-asset portfolios? The Fed has dampened expectations that its policy rate might go negative. Yet, should deflation loom, we think all options will be on the table, including driving yields far into negative territory, which in turn would help to push prices up further. We therefore believe that it still makes sense to invest a certain share of a multi-asset portfolio in government bonds. Investors who are more concerned about high inflation should consider holding a larger allocation to inflation-linked or real government bonds. However, we think that investors should also look for alternatives to adjust risks in multi-asset portfolios, especially if equity exposure is raised to increase return prospects. One way to add protection is to engage in hedging strategies using derivative markets, which should be actively managed over time as the costs of hedging and hedging needs change. Another way to add protection is to take market positions, which should provide strong positive performances during equity market downturns and flat to low returns otherwise. This again requires active management, but can help to buffer sharp equity market downturns, as our experience shows.
Bringing diversity to portfolios
Adding more asset classes remains a way to improve the trade-off between risk and return. Given low interest rates and a recovering economy, real estate should continue to offer attractive returns while providing a more income-oriented component. Investing part of equities in private markets provides another way to increase longer-term return prospects. Investing in longer-term themes such as those we identify in our Supertrends framework can also help raise portfolios’ longer-term return profile.
Further enhancing return prospects
In this context, investing according to environmental, social and governance (ESG) criteria is an important trend, in our view, that allows investors to direct portfolios toward projects that prioritize sustainability and good governance, which we believe are important for sustainability in performance as well. Within fixed income portfolios, taking credit exposure is a way to enhance return prospects to preserve wealth. Credit spreads are still somewhat higher than before the crisis and suggest an overall attractive return outlook. A bias toward higher-quality segments still appears warranted, as the fallout from the pandemic is expected to lead to rising default rates in the lower-quality credit segments in the first half of 2021.
Anchor: forecasts
Forecasts
We expect that the global economy should grow by 4.1% in 2021 as demand continues to recover following the recession in 2020. With policy rates set to remain at or below zero in all major developed economies, equity markets should continue to provide attractive returns. In fixed income, returns on core government bonds will be meager at best, while credit exposure provides opportunities to enhance returns.
