- Investors expect rewards from risk assets in 2021
- Central bank policies to be more tolerant of inflation
- Principle of risk management and discipline remain crucial
The past 12 months have been about riding the wave of electronically created money and positioning to take advantage of trends accelerated by the Covid-19 pandemic. Looking further ahead, an inflection point has been reached for strategic investors. As well as turbo-charged impetus to technological, environmental and economic change, the policy response to the crisis has lasting implications for the role major asset classes play in portfolios.
Massive co-ordinated stimulus by governments and central banks underpins opportunities in clean energy and the irrepressible march of technology. But how it is all paid for – negative real interest rates and ballooning government debt – creates a headache for investors who are getting no real return from assets that are traditionally less volatile.
Being able to balance risky assets such as shares with steady returns from safer investments like government bonds is a cornerstone of portfolio theory. Principles developed by the likes of Professor Bill Sharpe, who spoke to us for this piece, require discipline, but deciding on a suitable risk strategy and asset allocation remains crucial.
Our strategic asset allocation models (see box) aim to provide a framework to manage risks. These weightings can help investors remain thoughtful of their tolerance of ups and downs as they pursue returns. Maintaining this perspective is helpful in managing the size of core holdings within each asset class, along with decisions to take tactical opportunities.
An appraisal of the outlook for different shares, bonds and alternative assets shows up several opportunities for 2021. There is much uncertainty to potentially reward or burn intrepid investors, but the long-term implications for core assets is of the greatest consequence.
UK shares to be volatile, but that could cut either way
With its services bias, Britain’s economy has suffered more than most peers during the pandemic. Optimism about the roll-out of the BioNTech/Pfizer vaccine has been tempered by the discovery of a new coronavirus strain, but UK share prices are continuing their bumpy recovery from March lows.
Stock markets look forward rather than backwards, so don’t represent the current situation on the ground and it remains to be seen how UK plc will recover once the virus is under control. The knock-on effects of higher unemployment and a potential slowing of the housing market, once the sugar rush from tax breaks wears off, mean businesses could find trading conditions tough for some time. This will cause share price volatility as analysts amend their forecasts for company profits.
To compound the uncertainty, 2021 is the first year Britain embarks on its future truly outside of the EU. The value of the pound is the biggest risk – a weak currency on top of possible new tariffs will import inflation. How this might tally with the Bank of England laying the groundwork for negative interest rates next year is a frightening prospect. The flipside to these worries is enormous potential for some UK shares to re-rate if the stars align and the Brexit outcome is positive plus Covid-19 restrictions can be lifted sooner rather than later.
Understandably, many investors in shares will prefer to focus on members of the FTSE 100 index, which earn more of their profits overseas. These businesses have scope to benefit from a global recovery, so even if the pound goes up, they are still worthwhile holdings. There is a caveat that some larger UK-listed companies (such as oil majors and banks) are in industries facing secular headwinds, which limits growth opportunities. Important, too, is the fact dividends cut in 2020 may take time to reappear.
Looking to overseas shares for quality and growth
Despite the uncertainty, shares are an asset class that is vital to achieving long-term investment goals. Work by Professor Elroy Dimson, Professor Paul Marsh and Dr Mike Staunton has shown that between 1900 and the end of 2019 the real return (after inflation) from global equities (shares), including dividends, compounded at an annualised rate of 5.2 per cent. Fortunately for investors concerned about the UK, it is now easier than ever to think globally.
Notably the UK market is poorly endowed with the kind of innovators that are leading the technology boom. The pandemic accelerated revenue growth for the likes of Microsoft (US:MSFT), Amazon (US:AMZN) and Alphabet (US:GOOGL) and the central bank response to the crisis has made quality stocks like these and Apple (US:AAPL) relatively more attractive. The US Federal Reserve's move to slash interest rates and create money for quantitative easing (QE), means reliable cash flows from companies with high sales and proportionately few fixed assets to replace are appealing, even if the shares were already expensive.
Big tech companies aren’t having it all their own way, however. One of the arguments for their continued growth – that they are permanent monopolies – is drawing serious threats to break them up. Regulators in both the EU and the US are taking aim, with social media giant Facebook (US:FB) under special scrutiny over its ownership of Whatsapp and Instagram.
Monetary stimulus from the Fed has helped raise tech stock valuations, but other companies may benefit more from a government spending boost. The support package for 2021 is close to getting bipartisan support in the US Congress, although the extent to which president-elect Joe Biden’s green revolution happens will depend on whether elections in Georgia hand the Democrats control of the Senate. Despite the threat of higher taxes on corporations, more federal government spending is seen as being positive for many US shares.
American companies are prominent in advanced industries such as artificial intelligence and robotics, biotechnology and battery technology supply chains. These are all themes that can be played through investment trusts and exchange traded funds (ETFs). Along with infrastructure and other clean energy investments, these are recovery and growth sectors to focus on.
Companies at the cutting edge of new technologies provide some of the best opportunities in Europe and Asia, too. There are interesting thematic funds for investors to target environmental services and renewable energy, as well as thriving industries such as fintech – which has seen usage explode in the pandemic. These niche areas are a good focus for European growth once lockdowns ease and government stimulus programmes have an impact. Europe’s best industrial, consumer goods and luxury businesses will also benefit as the world economy reopens.
China’s recovery is gathering impressive momentum already. Its world-class technology businesses mirror the steady cash flows and growth of their western counterparts. The likes of Tencent (HK:0700) and Alibaba (HK:9988) are expected to continue their outstanding performance but, while not cheap, they are still valued less expensively than US tech.
Although China now accounts for a large part of the MSCI emerging markets index, actively managed funds are arguably a better way to invest in the economic powerhouse. This is desirable to avoid state-owned enterprises and companies bid up to frothy valuations by domestic retail investors. Also, because shares in Chinese companies are listed in Hong Kong (H-shares), Shanghai and Shenzhen (A-shares) and in the US (through American depositary receipts, or ADRs), it is useful to have an expert navigate the complexities and anomalies.
Asia and the growth of its cities, consumption patterns and indeed capital markets, is a huge opportunity. The recently signed Regional Comprehensive Economic Partnership (RCEP) is an important landmark that also bodes well for the Association of South East Asian (ASEAN) countries.
Japan is also a signatory of RCEP, although in the short term some sectors of its economy may suffer from cheaper competition as a result of the deal. Nonetheless, Japan is an important stock market and many of its companies went into the coronavirus crisis less indebted than those in the west. Reasons to be cautious include rising coronavirus infection rates, but Japan has done well to stymie its epidemic up until vaccines are firmly in the pipeline.
Prospect of negative interest rates create fixed-income conundrum
Shares give investors a stake in companies that generate profits and compound away in value, which is probably the most powerful source of wealth creation over time. But companies take risks, so investors also need to hold other assets.
Bonds are the other major component of most portfolios. They are issued by governments and corporations to borrow money for a fixed term, although the initial lender can sell the security on, transferring the rights to income and repayment. As an asset class bonds are referred to as fixed income because they pay investors a set amount or ‘coupon’ at regular intervals. At the end of the bond’s life, the holder is paid the principle sum that was lent to the issuer.
The bond market is incredibly complex because they are tradeable instruments, often not held to maturity by the original purchaser. As the coupon is fixed, prices must fluctuate in order to reflect market yields, and by extension bond prices are sensitive to changes in interest rates. This means there is a risk to capital.
Despite this, lending to some entities like stable governments is much safer than investing in shares. Bonds from governments like the UK or the United States are subject to interest rate and inflation risk but are considered virtually free of default risk, so they are important in portfolios.
If held until their redemption date, the yield on quality government bonds is a guaranteed rate of return. For short-dated bonds, which have less sensitivity to interest rates, this rate is unlikely to change and is therefore risk-free. This concept is central to the work of Professor Sharpe (see box) as it means investors know the reward (or when rates are negative the cost) for just parking money with a safe entity in the knowledge it will be returned at a fixed point in the future.
Policy revolution to mitigate interest rate risk and favour inflation-linked bonds
When risk-free rates were positive, there was scope for bond prices to rise and offset falls from shares. If interest rates were cut to stimulate the economy bond yields would fall too and the inverse movement of bond prices mitigated an overall decline in portfolio values. This is what happened in the 2000s, in what was a dismal decade for shares.
Now there is less scope for prices to work as favourably. Still, short-dated gilts are an important core portfolio holding for a UK investor; mainly to dilute the risk of price falls in other assets, even if they are no longer so able to offset them.
For longer-term holdings, inflation-linked bonds make more sense than those with nominal yields. This is a calculated risk, however. If inflation were to return significantly in the next couple of years (which can’t be ruled out), and interest rates increase, the fall in the capital value of bonds could outweigh any inflationary rise in coupon payments.
That said, some market strategists think central banks will be more tolerant of inflation as growth returns to the economy and they will work to keep nominal yields low. Certainly, given the policy is to kickstart growth around the world with massive government spending funded by cheap debt, there is serious incentive to suppress borrowing costs.
It follows that investors will have to moderate their expectations of what the BlackRock Investment Institute terms “the new nominal” for rates. Its chief fixed income strategist, Scott Thiel, explains: “We see stronger growth and lower real yields going ahead as the vaccine-led restart accelerates and central banks limit the rise of nominal yields – even as inflation expectations climb. This implies that nominal yields will be less responsive to rising inflation risk than in past episodes – this is central to the theme of policy revolution.
“With government yields already quite low we believe that nominal bonds have a limited role to play in a multi-asset portfolio both from a total return and a risk management perspective," Mr Thiel adds. "Overall, this means that our recommendation is that investors reduce their weight in nominals and lean into inflation-linked bonds, which are primed to benefit from a risk-on environment with an eye towards the slow and steady rise in inflation.”
Another way that investors can seek a higher real rate of return is by taking on more credit risk. Corporate bonds have a higher risk of default than the debt of quality sovereign issuers, so their yields offer a spread over that of comparably dated government bonds. Spread compression occurs when investors believe corporate credit is less risky and signifies the best ‘investment-grade’ (IG) credit is getting expensive.
In response to this, some investors move to riskier high-yield (HY) corporate bonds, where the issuer must offer the inducement of more yield to compensate for greater likelihood of default. Another option is to invest in emerging market debt, from sovereign and corporate issuers, in both local currencies or denominated in so-called ‘hard’ currencies such as the US dollar or the euro.
Spread compression is symptomatic of a risk-on environment, when investors calculate that more adventurous choices will pay off. Portfolio managers still need to control the overall level of risk they are taking, though. This means that, although that risk-free rate on short-dated government debt is negative in real terms, it is still worth holding as an anchor to stop the portfolio strategy drifting. Basically, a barbell approach is required between low risk and low (even slightly negative) return investments and those that are high risk/high return.
Alternative risk assets: real estate, gold and cryptocurrencies
Global real estate is an asset class where returns are in kilter with the real-time economy (the stock market is more forward-looking), so diversifies some cyclical risk. In the UK, people will contrast the stamp duty holiday and other incentives buoying residential sales data with the dire straits commercial office and retail lettings are in. Yet this is a global asset class and investors can buy ETFs and managed closed-ended funds to broaden their exposure in Europe, Asia and North America.
Some areas of commercial real estate have done very well during the pandemic, such as the warehousing businesses and properties that are central to fulfilling deliveries for digital retailers such as Amazon and Alibaba. Furthermore, working-from-home dynamics aren’t likely to be the same in places such as Hong Kong or Shanghai as they are in London. Property markets in the world’s great cities are as distinct as their characters and cultures.
By contrast, gold is the same the world over. Traditionally it’s excellent as a portfolio diversifier because its price rarely moves perfectly in tandem with shares or bonds. Furthermore, should there be an inflation shock, the protection gold offers as a store of value is considerable.
Secular decline of fiat currencies, in a world of mountainous debt and slow growth, is another argument gold bugs are fond of. With global growth likely to be driven by Asia, the US dollar may eventually come under pressure as global reserve currency. The greenback has shown weakness towards the end of 2020 and more money printing and US government borrowing will continue to add to the bear case.
What replaces the dollar is more up for debate. China’s renminbi will become more important as will cryptocurrencies. Assets such as Bitcoin proved wildly popular for speculation in 2020, especially among younger investors. There is a likelihood of large intraday falls, however, so investors shouldn’t be allocating more than a slither of their portfolio to such speculation.