Most investors acknowledge that markets are at high valuations although there is active debate as to whether this is a sign of impending reversal. I think not. The macro environment of ample liquidity and eventual post-COVID recovery should support the performance of those assets that have done well in the last six months. In fixed income, the returns may be constrained by low yields and the potential for risk-free rates to move a little higher, but credit intensive and equity-like fixed income should still perform attractively on a risk adjusted basis. In equities, there is the prospect for small cap and emerging market equities to reward traditionally higher volatility with ongoing strong return performance. The reflation trade can be built on a number of pillars and should perform well until either the liquidity or growth outlook changes materially for the worse.
Risk and return
A fundamental input into making allocation decisions at the asset class level is to consider prospective returns measured against expected volatility. This can be done on the basis of forecasting returns but very often, investors rely on the history of performance and how that evolves through different parts of the economic cycle. Over the last year, there has been quite a dispersion of risk-adjusted returns. Most asset classes saw a drop in returns in H1 2020 as a result of the COVID19 shock and the increase in volatility of performance. However, the last six months has been characterised by risk-on, plentiful liquidity and an outperformance of assets that have had traditionally higher return and volatility profiles. Growth and liquidity are expected to remain supportive in the coming quarters suggesting that momentum plays will remain in favour – what has done well should continue to do well as long as the overall market regime does not change materially.
Dispersion of performance
Using a simple metric, I looked at the performance of various fixed income and equity assets over the last five years and the last six months. The metric is the annualised total return performance during those time periods over the annualised volatility of those returns. The higher the number, the more the asset class returns for every “unit” of volatility. The range of assets runs from US Treasuries right through to emerging market equities. The risk-adjusted ratios run from around 0.4 to 2.2 and generally, over the last five years, fixed income assets have delivered higher risk-adjusted returns (though not necessarily higher absolute returns).
I don’t think higher Treasury yields are a major problem for the global economy or risky assets as long as the move is not too rapid or goes too far. However, the last six months has been interesting. The best performing assets have been credit intensive and equity-like fixed income, with sectors like leveraged loans performing better than the five-year average. High yield and convertible bonds have also been notable performers. With growth due to accelerate and credit concerns diminishing, this should continue to be the case even with lower yields. In the equity markets, the best performers have been emerging markets, small cap and Japan. All have shown better risk-adjusted performance over the last six months relative to their five-year history.
Low returns from government bonds
What is also clear is the poor performance of government bonds. The suppression of yields has reduced income return and while government bonds did well during the market turmoil last March, since then they have underperformed. Even with low volatility, this has reduced their attractiveness from a return point of view. In the first three weeks of the year, benchmark yields on risk-free government bonds have increased. If the economic outlook is going to improve then this trend is likely to persist, keeping returns very low or even negative.
Rolling one-year risk-adjusted returns collapsed in Q1 last year for most risk-assets (government bonds, as mentioned above, did better). Since then there has been more stability in the trend of risk-adjusted returns but for most asset classes the performance of this metric remains below the medium term history. This is consistent with current high valuations and an expectation of low returns going forward. Yet, investors need to invest. The macro scenario suggests betting on those asset classes that do have continued upside in terms of risk adjusted returns. In line with the conclusions of our end-of-year market outlook, the broadening and strengthening of the economic outlook, which should accompany the progress towards herd immunity, supports allocations to small cap and emerging equities, including China, as well as convertible bonds, high yield, loans and emerging market debt. Growth equities – such as the S&P Growth and Nasdaq indices – came off the boil towards the end of last year and could see some catch up towards their longer-term performance (although I suspect volatility remains high given concerns about tech regulation and the potential for earnings volatility), while China has accelerated higher since the beginning of the year (MSCI China index has had a total return of 12% already this month). There are numerous options for building a reflation bias into investment strategies.
Investment grade credit looks somewhat dull. Risk-adjusted performance over the six month period is well below the five year standard and market level valuations are rich. The US investment grade market saw a 46 basis point (bps) tightening in spreads in Q4 but the outlook now is for much more limited spread tightening going forward and a risk to total returns from higher Treasury yields. In Europe, the all-in yield on the corporate market is just 24bps. Yet the market remains buoyant with new issue activity continuing at a high level. As a side note, there seems to be a perceptible increase in the issuance of sustainable and green bonds from a variety of issuers. This is a trend we expect to continue as borrowers satisfy the requirements of more ESG driven investors, benefitting from slightly lower borrowing costs as a result.
Markets greeted the inauguration of Joe Biden as the 46th President of the United States with new highs in equities. The challenges of the new Administration are well documented, particularly in respect of the very thin majorities the Democrats hold in Congress. However, the policy agenda is ambitious and the speed at which a number of executive orders has already been issued is impressive. At the global level it is encouraging that the US will re-engage with the international community on climate change by re-joining the Paris Agreement and in combatting the COVID-19 pandemic through active participation in the WHO. Domestically, Biden has already demonstrated a new level of urgency on the pandemic front, tightening up rules on wearing masks and pledging to massively increase the vaccination programme in the US. Dealing with the pandemic is a pre-requisite for the kind of growth outlook that many in the market expect as it will improve the multiplier effect from fiscal stimulus over the next year or so.
The focus on climate change mitigation in the US under the new Administration will provide investment opportunities as well. Government spending on green infrastructure will accelerate the development of new technologies in fields like electronic cars and renewable energy capacity. We could see a greater share of the economy come under carbon emissions legislation through the extension of regional emissions cap and trade systems in California and the North East. This will also add to the speed of transition in a number of industries. As a theme for bond and equity investors, the energy transition will continue to be very strong this year.
I suspect leadership of the English Premier League will change hands a number of times before the season’s climax in May. The top four at the moment are four of the only six teams that have been champions over the last twenty years. Just like with investment performance, there tends to be persistence in football. The two Manchester teams are the current form teams but there are only six points separating top from fourth and they all have to play each other in the weeks ahead. For this weekend though, it is the Cup and another chance for Liverpool and Manchester United to try to score a goal against each other. There has to be a result from this tie, ensuring that one of the two can forget dreams of a League and Cup double. The action switches to Old Trafford for this one. I suspect it will be more entertaining than last week’s game. Liverpool’s confidence has been knocked but anything can happen when these two meet. Thank goodness lockdown provides no distractions from the TV on a Sunday afternoon!