Portfolios need a broader mix as pandemic prolongs uncertainty

December 15, 2020 10:03
Photo: Reuters

While investors can approach 2021 with optimism that an effective Covid-19 vaccine will be available, the path of the economic recovery remains unclear.

The global economy has recovered from the depths of the Covid-19 recession even as some countries grapple with new infections and lockdowns. Investors may want to seek out new sources of return potential that could benefit from the evolving recovery story – in addition to sectors that have prospered through the crisis.

Much depends on the successful deployment of an effective vaccine and drug therapies. New vaccines appear to hold promise, but we will be watching key macroeconomic data points for signs of momentum – and we expect wide differences in how regions perform. If the coronavirus is contained, attractive areas may include European and Asian equities, value sectors and corporate bonds. For institutional investors, private markets offer potential – infrastructure in particular could see increased spending, thanks in part to stimulus measures meant to boost economic activity. There are also an increasing number of opportunities to support a sustainable, resilient recovery of the post-coronavirus economy in ways that address climate change and other vital issues.

But if the pandemic is not brought under control, economic activity seems likely to reach pre-coronavirus levels only by the end of 2021. Economies might not return to their pre-coronavirus trend path for several years.

Countries have used stimulus to fight the coronavirus – but there may be economic casualties in the long term.

In response to the recent recession, governments and central banks provided vast amounts of monetary-policy stimulus and fiscal stimulus. Although this support was necessary and helpful, it may also result in painful long-term side effects that include:

-High asset prices in some markets. Excess liquidity from monetary stimulus (essentially, too much money in circulation relative to economic activity) lifted asset prices – even some that already appeared overvalued. We think this is particularly true with government bonds and US equities, while non-US equities appear more moderately priced.

-High leverage. Public and private debt levels are elevated. If the recovery weakens significantly, companies might struggle to maintain their debt burdens – raising the risk of defaults. In addition, weak companies that renew cheap bank loans can turn into “zombie companies” – businesses with low productivity, high debt and a high risk of default if rates normalise.

-Rising inflation volatility. Risks are mounting that the prices for goods and services will grind higher in the medium term due in part to the excess liquidity from monetary stimulus, but also due to supply-side shocks related to the coronavirus shutdowns and ongoing trade wars. A continuation of the deglobalisation trend – as countries seek to be self-sufficient with essential goods – would be a drag on long-term economic growth and, consequently, on productivity growth. All else being equal, this could point to higher price volatility globally in the coming years.

Four investment themes to watch in 2021

1. Financial repression “reloaded” and massive government debt could drive up long-term yields

Given the support that central banks pledged in the face of Covid-19, we expect short-term interest rates to remain at ultra-low levels for the foreseeable future. This is essentially a “reloading” of the financial-repression policies (including low interest rates, restricted capital flows and other regulations) that central banks implemented after the financial crisis to help their economies grow their way out of debt. In our view, continued intervention by central banks is necessary, but it could still lead to higher inflation and other problems (as noted above) in the medium to longer term. In addition, a huge supply of sovereign bonds – the direct consequence of extremely expansionary fiscal policy – will continue to flood the bond markets in the coming quarters.

2. Equities could benefit from positive news about the coronavirus - but balance and selection are key

Amid the upheaval of the Covid-19 pandemic and accompanying lockdowns, certain regions and asset classes did quite well – particularly US large-cap technology and online retail names that benefited from the “stay-at-home” trend. Positive developments in the fight against the coronavirus could help a broader range of stocks and regions in addition to these “coronavirus winners”.

One such positive development was the announcement of promising vaccine trials towards the end of 2020. Yet it remains unclear how long it will take to roll out these vaccines and how many people will be willing to get them. Until then, many regions will likely grapple with subsequent waves of coronavirus infections. So as we wait for effective vaccines and therapeutic treatments to be broadly adopted, the growth outlook will be unclear and private-sector spending (including private consumption and investments) could be suppressed.

If cyclical economic data lose momentum, equities could suffer – particularly if the markets see a disconnect between asset prices and the underlying health of the economy. Since there are still many unknowns for the markets, we suggest investors consider investing in a balanced equity portfolio rather than looking for a simple directional call that would indicate how to invest.

3. The US dollar seems more likely to weaken, which would benefit non-US markets

As the global economic rebound ramped up, the US dollar fell in value relative to other currencies. While some economists see a turnaround on the horizon – in large part because uncertainty about Covid-19 is supportive for “safe-haven” assets such as the US dollar – we are slightly more inclined to believe the dollar will fall for several reasons:

-The dollar is still historically overvalued.

-US monetary policy is “easing” more aggressively than non-US monetary policy (including the Federal Reserve moving towards targeting an average inflation rate). Easy monetary policy tends to weaken a country’s currency.

-There are no signs of US dollar funding stress – unlike what happened early in 2020, when companies and countries scrambled to obtain dollars.

A weaker US dollar could be positive for certain large US companies that get much of their revenues overseas, since other countries would have additional buying power to purchase US goods.

More likely, a weaker dollar indicates that the markets feel non-US economies have stronger prospects. This could be a good sign for non-US markets – particularly in Europe, which is undervalued compared with the US.

Moreover, emerging-market equities that enjoy current-account surpluses – meaning they benefit from net exports – also tend to outperform developed-market equities during periods of US dollar weakness.

4. Sustainable investing provides the long-term view investors need

The coronavirus pandemic exposed shared vulnerabilities in the global economy and the systems on which we all rely. Investors will increasingly need to find ways to be selective among sectors and individual names, rather than rely on broad market performance. Environmental, social and governance (ESG) factors can be a helpful lens for highlighting major global risks and testing the resilience of businesses and systems.

The Covid-19 pandemic also forced many investors to hit the “reset” button and recalibrate their priorities, with policymakers, regulators and investors examining the social effects of economic activity. A growing number of investors will want to put their capital to work in a sustainable way, and they’ll be looking for creative ideas to help achieve meaningful real-life change on topics such as climate change.

This may happen within the framework of the 17 UN Sustainable Development Goals (SDGs), which call for greater cooperation between countries, organisations, companies and individuals to address vital development issues. A 2017 UN report put the SDG funding gap in developing countries at around USD 2.5 trillion per year, making it critical to find innovative and scalable new investment products for the countries and sectors most deprived of funding. This can take the form of public/private partnerships, with parties with similar goals shouldering different responsibilities. The field of development finance – which uses capital and know-how from public and philanthropic sources to mobilise private investment into sustainable development – can play a crucial role here. For example, given that massive spending is still needed to return parts of the economy to its pre-pandemic growth trajectory, some governments see an opportunity to rejuvenate existing infrastructure such as electricity networks. This can be done while building the social, environmental and clean-energy projects that will support the well-being and prosperity of future generations.

But sustainable investing is not just about doing good – it also helps investors seek solid performance. Approximately two-thirds of active ESG managers in the eVestment database (which tracks institutional asset managers) have beaten the benchmark index for global equities during the last three years. This includes 2020 – an extremely volatile period for equities.

For investors who want to put their money to work in a sustainable way, there are many options, particularly as the world recovers from the Covid-19 pandemic.

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Head of Global Economics and Strategy, Allianz Global Investors