Finding the right asset mix for long-term investment goals is challenging in the best of times. Today, the dilemmas are even more daunting. In conversations with clients, we’re hearing recurring questions about diversification that require innovative solutions for unusual market conditions.
In early 2021, investors have become increasingly upbeat about the world’s path to recovery from the pandemic. But ironically, this optimism has fueled market trends that add uncertainty to the outlook. Bond yields remain extremely low, but a shift may be beginning. Stock market valuations—particularly in the US—look relatively high. Mounting expectations of accelerated economic growth are tempered by distinct country-specific experiences and policies. Massive fiscal stimulus could resurrect inflation, yet investors are rusty at addressing this long-dormant risk.
Against this backdrop, we’re hearing one underlying question from clients: How do you meet target premiums with persistent low yields and elevated valuations? While there’s no one-size-fits-all answer, three principles can help point the way. First, think critically about how the recovery will unfold and don’t be seduced by simplistic headlines. Second, check that your exposures offer diverse sources of return—both within and across asset classes—for changing conditions. Third, strike a balance between capturing diverse sources of return potential and securing adequate protection against complex risks, even if this exacts a short-term performance cost in some cases.
1. Prepare for a Bumpy Three-Phase Recovery
Every investment planning discussion today must begin with an assessment of the pandemic exit path and its macroeconomic implications. While much is still unknown, we project a three-phased recovery, each presenting investment challenges given the opaque outlook.
In early 2021, Phase 1 of the pandemic recovery began to unfold. COVID-19 vaccination programs began to gain momentum around the world, though some countries are far behind and many experienced new peak infection and mortality rates that began to retreat in February. These developments present a conundrum for investors seeking signs of economic improvement as governments struggle to balance reopening efforts against fears of a virus relapse.
By late February, we started to see the first signs of Phase 2. Efforts to contain the pandemic began to succeed at reducing the spread of coronavirus in the US, Europe and Asia. This raised hopes that economic activity could soon reopen—albeit at a “new normal” level—and consumers would unleash pent-up spending. By midyear, we believe many companies will report strong recoveries in earnings growth, especially given the low level of comparable profits in 2020.
Yet the road to a sustainable recovery won’t be smooth. By 2022, after the initial sharp rebound, companies are unlikely to post such rapid growth. And as the world begins to normalize during this third post-COVID phase, we’re likely to find that economic growth faces the same hurdles—and likely the same risks—that prevailed before the pandemic.
Through all three recovery phases, investors should brace for periodic market turbulence. Indeed, in late February, US Treasury yields jumped, prompting market volatility as investors began to digest the implications of rising interest rates on different types of assets. But with a solid conceptual framework, it should be easier for investors to calibrate exposures to realistic market expectations and to maintain firm strategic allocation plans through uncertainty.
Where Will Interest Rates Go?
Interest rate expectations underpin any investing outlook today. Record low rates have become a persistent source of uncertainty for investors, with central banks pledging to maintain extremely loose monetary policy to support COVID-stricken economies.
For bond investors, low yields make it harder to find income while raising concerns about the efficacy of sovereign bonds as a tool for risk reduction. Equity investors have seen low rates provide powerful fuel for growth stocks, while suppressing multiples for value stocks. These trends complicate diversification efforts within asset classes and between them.
Clients often ask us where we think interest rates will go through our three-phased recovery outlook. While global economic growth is expected to accelerate in the second half of the year, we don’t think interest rates will rise dramatically anytime soon. Since the recovery is very fragile, policymakers aren’t likely to let rates rise too far, too fast—even if inflation begins to materialize. Yields in most markets will probably stay low through 2021.
In the US, our economists forecast the 10-year US Treasury yield to reach 1.75% at year-end, from about 1.60% in mid-March. That’s below the level that prevailed before COVID-19, yet a 21% leap from the March 1 rate of 1.45%. Massive fiscal stimulus should help the US grow faster than other developed economies, prompting a faster increase in rates from 2022 than in the euro area and Japan, where rates are unlikely to turn positive. In all three regions, real yields were still negative by the end of January (Display).