- We have preserved a near full risk positioning in our portfolios since the end of Q1, reflecting expectations for a substantial rebound given the extraordinary policy response to the pandemic.
- We expect the pace of recovery to be slower from here, with full economic normalization accompanied by a potential rise in rates sometime in late 2021.
- Trade wars and a global pandemic have challenged portfolio performance over the past two years; underperformance was driven largely by our choice of execution vehicles rather than asset class allocation decisions.
- We have taken deliberate steps to improve performance: removing certain managers, adding tactical positions and narrowing the duration gap (though we remain short duration).
- As a sustainable economic rebound takes hold, we see a challenge to U.S. multi-year outperformance. We expect the market to rotate toward regions (e.g., China, Asia ex-Japan, emerging markets broadly) and sectors (e.g., U.S. financials and overly discounted cyclicals) previously out of favor.
- We have high conviction in our positioning and fully anticipate improved relative performance as the global economy normalizes and areas shunned in an environment of trade wars and pandemics return to favor.
Since the end of the first quarter, we have maintained a positive stance in our economic outlook as well as close to full risk positioning within our portfolios. This aligns with our expectation for a significant rebound (see CIO Pulse, Q1 2020) occasioned by a strong and ultimately unprecedented response on both the monetary and fiscal policy fronts (Exhibit 1). The 2008 policy response to the global financial crisis (GFC) was our guidepost for the current crisis reaction function and both monetary and fiscal policy exceeded expectations for doing “whatever it takes” to aid economies and ensure that financial markets continue to function normally.
Economic policymakers have responded to COVID-19 in unprecedented ways
Resulting expectations for a V-shaped economic recovery have proved well founded throughout the past three months, with the latest global data points in the U.S., Europe and China confirming the financial markets’ enthusiasm for risk assets.
The recently released U.S. Institute for Supply Management (ISM) non-manufacturing index, at 57.1, achieved one of the highest monthly upticks in the history of the series and the China Markit Services Purchasing Managers’ Index (PMI), at 58.4, hit a decade high. All in all, a better than expected economic trajectory has prevailed since the bottoming of the economy in the early part of the quarter, as best expressed by the Citi Economic Surprise Index (Exhibit 2B).
Latest indicators suggest global economic activity has more than met expectations
With the Chinese experience as an approximate guide, both in terms of COVID-19 containment and economic re-opening, we expect to see the recovery in the U.S., Europe and most of the emerging markets continue, albeit at a slower pace. The last mile to trend line growth—a return to more normalized activity levels in personal and restaurant services, air travel and other coronavirus-sensitive businesses—is likely to follow a more gradual trajectory, adding to our conviction that full economic normalization is a second-half 2021 milestone. The expected slowdown of the rebound later in the year, the recent uptick in U.S. infections, a possible second COVID-19 wave in the fall and the increasing focus on the upcoming U.S. election—all within the context of a nearly 40% run in global equity markets since the March bottom—argue for a correction of some magnitude, likely toward the end of the current quarter. Additional stimulus, however, should be expected later this summer and, if conditions slow materially from there, more may come in the fall.
Better conditions outside the United States are leading to relative outperformance abroad
Conditions both outside and within the U.S. have begun to challenge multi-year U.S. outperformance. Outside the U.S., those conditions include a superior COVID-19 containment experience (Exhibit 3) and, since June, what appears to be a sustainable global economic rebound. In terms of the U.S. itself, uncertainty surrounding election outcomes, unraveling social cohesion and elevated but not extreme valuations have contributed to a pause in U.S. market leadership.
A modest fall in the U.S. dollar (still materially overvalued on standard purchasing power metrics) contributed to U.S. underperformance in the latter part of Q2. U.S. leadership has been dominated by a handful of new economy innovators that now account for more than 20% of the entire S&P 500 market capitalization and have contributed significantly to YTD performance (Exhibit 4). We fully concur with the market’s upward revaluation of the FAANGMs* but doubt that outperformance can continue apace, particularly if better economic conditions instigate a broader synchronized growth environment. Regardless of our positive expectations for the intermediate and long-term fate of the FAANGMs, we believe the underperformance of U.S. market indices over the last two months is likely to continue, driven by further dollar weakness, the strength of Asian technology and consumer services, the relative cheapness of emerging market equity based on price to book metrics and the substantial underweights to the Asian and emerging markets in most globally-benchmarked portfolios.
*Facebook, Amazon, Apple, Netflix, Alphabet’s Google and Microsoft.
The spread of COVID-19 has been relatively well-contained in Asia
U.S. market leadership has been dominated by new technology FAANGMs
Portfolio positioning and the alpha potential in a normalizing global economy
Our portfolios have underperformed expectations over the past two years as economies and investors struggled with an unprecedented global pandemic and destructive trade war. Prior to the trade war and in the interlude between the trade war and the pandemic, portfolios performed well relative to their benchmarks.
Underperformance was largely driven by our choice of execution vehicles rather than asset class allocation decisions. Our underweight to duration within fixed income was an additional detractor. Despite our active and, on average, additive tactical adjustments, our positioning for a normalized global economic environment proved to be incorrect, with implications throughout the portfolio.
We fully anticipate that the normalization, albeit non-linear, of economic and health conditions will cause a corresponding normalization in investment markets. We expect historically wide valuation gaps to narrow, the U.S. flight to safety to subside and global cyclicality to offer support to non-U.S. markets—particularly emerging markets.
A brief review by asset class of our expectations and the steps we are taking to adjust portfolio positioning should help explain why we anticipate better relative performance over the coming quarters.
We have made numerous changes to the fixed income allocation over the past year. For example, in an effort to cautiously enhance yield, we have added high grade corporate bonds while maintaining a moderate exposure to core bond managers who hold higher than average credit exposures. We have also narrowed the duration gap relative to the benchmark but remain modestly underweight duration with the expectation that economic policymakers will achieve their goal of normalizing economic and market conditions, eventually allowing for a gradual rise in rates. Despite our duration underweight, the yields of our fixed income allocations are higher than that of the benchmark—a result of our high grade credit and mortgage exposures.
The Fed’s massive injection of liquidity, reflecting its full commitment to normalizing growth and achieving its 2% price level target, appears to have been the drastic support needed to rescue both the economy and markets. It is also contributing to a recovery in long-term inflation expectations as expressed by TIPS breakevens. However, even against the backdrop of unprecedented stimulus, the yield on the U.S. 10-year Treasury remains well below 1%. We believe this historically low yield is more reflective of broader uncertainty and a desire for safety than of longer-term economic fundamentals. Meaningfully rising rates will likely require a fully normalized economy and headline inflation consistently above 2%, which we expect sometime in 2021. This would, in turn, likely catalyze a move toward positive real rates in the intermediate and longer end of the yield curve.
Equity positioning also anticipated a revival of economic growth post the trade war, both through an overweight to Asia ex-Japan and broad emerging markets as well as through value-tilted active managers in our EAFE/Europe allocations. The active value tilt has been one of the largest sources of underperformance in U.S.-based portfolios. These managers, however, had relatively strong second quarters, recouping a good portion of YTD underperformance. While we are constantly evaluating the balance between our growth and value exposures, we are confident that our cyclical exposures should have more upside potential given the context of a rapidly recovering global economy, on-going central bank stimulus and an almost fully recovered Chinese economy.
Overweights to China and Asia ex-Japan are now adding value as both are outpacing the ACWI benchmark and, just as importantly, ahead of the S&P 500, YTD. We have recently added a position in Brazil since the Brazilian real has historically had the most upside among major currencies in a falling U.S. dollar environment (the real is down roughly 30% vs. the dollar, YTD). Additionally, Brazil has high exposure to cyclical sectors and its equity market has lagged the broad emerging markets benchmark. This is despite the fact that Brazil is an important exporter of commodities to China and commodity prices have performed well over the past few months.
Our U.S. equity exposure has changed materially with the removal of a large cap manager that had a history of core-growth characteristics but shifted toward value in 2019 and accentuated that stylistic exposure during the early days of COVID-19. That manager has been eliminated from our portfolios and we are in the process of building active growth exposures by combining a Nasdaq 100 ETF (in the case of U.S. portfolios) or a Technology ETF (in the case of international portfolios) with a growth-oriented active manager.
The U.S. financials allocation has weighed heavily on performance in 2020 despite the sector’s very attractive valuations and banks’ successful navigation of recent Fed stress tests. Uncertain capital returns, loan loss risk, and prospective profitability are key headwinds to near-term performance for the sector. We remain confident that U.S. financials have durable business models and that their balance sheets are strong enough to effectively weather the recession; we see current prices as an opportunity for purchasing well-managed businesses well below their fair value. Upcoming earnings for financials, and more specifically banks, could act as a potential near-term catalyst for a rerating of the sector and its outperformance relative to other parts of the market.
The allocation to physical gold together with the gold mining equity exposure have performed well by all accounts. We expect (a) further outperformance as we transition from a risk-off hedging use of gold to a hedge against rising medium-term inflation expectations and (b) in the case of gold equities, a potential earnings surprise story as the gold miners have production breakevens well below current gold prices. Additionally, company balance sheets are vastly improved from the last cycle and management teams seem, thus far, to be focused on operating with improved governance and capital allocation plans while maintaining some form of capital return.
Our small allocation to a broad but energy-tilted commodities manager was purchased in mid-February when the coronavirus was seen as a Chinese problem, the oil market was strong, the global economy was recovering from the trade war and Iranian threats to the oil lanes in the Gulf were taking place. While underwater YTD, this allocation turned in one of the best performances of all portfolio assets during May (+19%) and June (+5.8%) and strong gains are continuing in July. We anticipate further upside potential as oil capex has been curtailed and oil demand typically resurfaces as global economic growth normalizes.
We remain constructive on global equities on a one-year forward basis. Our view is predicated on the continued reopening of the global economy, the lagged and partially unspent monetary stimulus (Exhibit 5), the dry powder available to consumers from high savings since the start of the pandemic as well as our expectation for further fiscal support. These factors should also contribute to an uptick in interest rates, which would benefit our below-benchmark duration fixed income allocation.
Volatility in equity markets is certainly a risk and its level would likely vary with COVID-19 fears as well as concerns around a change in policy coming from Washington. We would be buyers of risk assets should a correction occur, given the reasons outlined above and the rising probability that a vaccine emerges over the next 12 months from the over 100 companies and research institutes currently pursuing it.
Over the next few months we will continue to build out an internationally diversified barbell between secular growth stocks and overly discounted cyclicals. We recognize the long-term value of innovation and growth, but would note that certain companies within the value space have been significant underperformers, despite having strong business models. Such companies could prove to be attractive investments over the near term should continuing economic recovery drive their multiples higher.
We have high conviction in our positioning and fully expect to recover relative performance as the global economy normalizes and regions as well as sectors previously shunned in an environment dominated by trade wars and pandemics regain favor.