Model Portfolio Updates: Key Asset Class Views for May
Overall, our model portfolios are underweight risk assets, and we favor credit within fixed income.
We meaningfully reduced risk assets to a net underweight position while deploying proceeds into bonds.
We recently wrote about the tactical active asset allocation decisions made by our model portfolio team during our March and April meetings amid the multidimensional uncertainty brought on by the COVID-19 health crisis. We provide an update on our key asset class views here, as discussed during our latest meeting on May 11.
Overall, our view on the impact of COVID-19 on economic growth has not changed. We continue to expect improved economic growth in the second half of 2020 and into 2021. Given the unprecedented amount of stimulus introduced to improve the functioning of markets and provide stopgap funding in many economies, the recovery should be well supported. We need to be mindful of signs of a possible second wave of infections in countries that have eased confinement guidelines—such as China, Germany and South Korea—to understand how that may impact policy if governments determine that economies may be reopening too quickly and the resulting regulatory response. Further, while developments in the treatment of COVID-19 have progressed, this will be a very fluid process, and at this point, there appear to be few definitive advances. In our view, this indicates an increased risk for prolonged social distancing measures, which would pose incremental negative consequences for economic growth and markets.
Markets have shown significant resilience and have bounced significantly from their lows in March. As we look forward, it raises the question of “too much, too soon” and the path ahead. To help frame that, we look to understand investor risk sentiment. Our Market Regime Indicator (MRI) is a tool that looks at implied volatility in equity and currency markets and at spreads on risky debt to give a global, multi-asset perspective on how investors are pricing risk. This indicator had been elevated to extremes, which is a positive contrarian indicator for us. But recently, the MRI retreated to a high-risk regime. In some respects, this can be viewed as an encouraging development, as equity and currency market implied volatilities have dropped and credit spreads have tightened. The still-elevated MRI reading, however, suggests that global equity markets are more vulnerable to shocks than usual and may still give investors a bumpy ride.
Key asset class views: Becoming much less constructive on global equities Our models have become much less constructive on global equities. Valuation is a notable driver, as strong price returns and weakening earnings have combined to create stretched readings. In addition, the steep decline in economic activity has depressed earnings sentiment, with both top-and bottom-line forecasts seeing downward adjustments. While the drop in earnings expectations is not a surprise, and we have been adjusting qualitatively, expectations are that this will continue and struggle to support the price multiples in equities. What’s more, the strength in the recent April rally indicates the potential for a price reversal, which is also pressuring equity forecasts. Specifically, European and US small caps are challenged by weak medium-term momentum indicators, as investors worry that these segments may be more impacted by weak economic growth, given their higher leverage profiles. In particular, US small caps have return forecasts similar to those of other equity segments but are more vulnerable to the impact of social restrictions on their business models, and they come with higher risk.
The prospects for REITs continue to deteriorate, as recent underperformance weighs on momentum and relatively poor and declining expectations for sales and earnings drag on sentiment. In addition, record unemployment and restrictive social distancing guidelines continue to stifle demand as the retail, hospitality and food services industries remain under extreme duress. Added to these factors is a consumer demand shift to online shopping, which is likely to materially impact cash flows and dividends for REITs in 2020.
Credit valuations are more attractive, with our models anticipating slight spread tightening driven, in part, by an overall lower level of interest rates. Credit risk premia on corporate bonds provides an attractive incremental return, but with less risk than equity. Furthermore, while earnings pressure could impact dividends for equities, bond cash flows are more insulated. Finally, while some factors appear less favorable, such as seasonality and elevated volatility, the Federal Reserve backstop provides important direct support for segments of the credit markets.
Directional and relative value trades reflect near-term risks for equities With this information in mind, the team meaningfully reduced risk assets (-4%) to a net underweight position while deploying proceeds into investment-grade credit and high yield bonds (+4%). Our decision was driven by heightened levels of risk aversion, deteriorating equity forecasts, and concerns over economies reopening too quickly.
The shift from equity to credit reflects our concerns about near-term risks for equities as well as a preference to take risk in the credit space. Equity markets appear to be stretched, with earnings uncertainty and the reemergence of trade conflict talks coming back to the headlines, leaving stocks vulnerable to a near-term correction. Corporate bonds are attractive in several regards, including valuation, policy support and risk profile. As a result, we sold 1% each of US small-cap and European equities, and 2% from US REITs. With the proceeds, we purchased 2% of intermediate investment-grade credit, 1% of long investment-grade credit and 1% of high yield.
Investors are dealing with multiple layers of uncertainty, ranging from medical advances to battle COVID-19 to central bank policy to the reactions of consumers and companies as the global economy reopens. Improvements will not happen in a straight line, and with that will come volatility. But it also creates an opportunity to be nimble and take advantage of disruptions in the market.
Bloomberg Barclays US Treasury Bill 1-3 Months Index The Bloomberg Barclays 1–3 Month US Treasury Bill Index (the "Index") is designed to measure the performance of public obligations of the US Treasury that have a remaining maturity of greater than or equal to 1 month and less than 3 months.
Bloomberg Barclays US Aggregate Index A benchmark that provides a measure of the performance of the US dollar denominated investment grade bond market, which includes investment grade government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities and asset backed securities that are publicly for sale in the US.
Bloomberg Barclays US High Yield Index The Bloomberg USD High Yield Corporate Bond Index is a rules-based, market-value weighted index engineered to measure publicly issued non-investment grade USD fixed-rate, taxable, corporate bonds. To be included in the index a security must have a minimum par amount of 250MM.
Bloomberg Barclays Commodity Index Bloomberg Commodity Index (BCOM) is calculated on an excess return basis and reflects commodity futures price movements. The index rebalances annually weighted 2/3 by trading volume and 1/3 by world production and weight-caps are applied at the commodity, sector and group level for diversification.
Market Risk Indicator (MRI) A proprietary macro indicator developed by the SSGA Investment Solutions Group. The MRI is designed to identify a level of forward-looking, implied volatility. Factors utilized to generate the signal include implied equity and currency volatility as well as spreads on fixed income.
MSCI Emerging Markets The MSCI Emerging Markets Index captures large and mid-cap representation across 23 emerging markets countries. With 834 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
MSCI Europe The MSCI Europe Index is a free-float weighted equity index designed to measure the equity market performance of the developed markets in Europe.
Russell 2000 Index A benchmark that measures the performance of the small-cap segment of the US equity universe.
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Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic orpolitical instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
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