Asset Class Opinions as of March 17, 2020
Bonds and Stocks
Our Global Tactical Asset Allocation strategy is overweight equities on the belief that the rapid bear market selloff has made valuations more attractive than they have been in some time, while a bond yield below 1% offers very little reward on that side of the ledger. Although we don’t know where the stock market might bottom, the 30% price cut since mid-February has significantly improved the risk/return profile of equities. Treasury yields are painfully low, but credit risk is rising such that taking on significant exposure here doesn’t seem appealing today. We are big believers that monetary and fiscal policy play key roles in market performance, and the massive efforts being made to blunt the impact of the coronavirus could provide ample fuel for a strong recovery as the health situation improves.
Governments and Credit
Investment grade spreads are widening as economic uncertainty grows, even as government bond yields are pushed lower by policy actions. We expect IG spreads to remain wider than in recent times, and since corporate balance sheets are generally strong, we are not projecting a large rise in defaults. We are neutral on IG credit.
Investment Grade and High Yield
Economic conditions are deteriorating and the Energy sector—which makes up more than 10% of the high yield universe—is in substantial distress. Although HY spreads have widened significantly, we remain wary of this space. The ultimate impact of business closures is unknowable, and the most levered companies will likely face significant cash flow stress. This may prove to be the event that finally flushes some of the zombie companies from our economy. We have no position in corporate high yield at this time.
Higher and Lower Rates
Interest rates have been pushed to new lows and the fed funds rate is near zero. We expect unusual monetary conditions to remain in place for some time and we are not projecting a short-term rise in rates. However, the next eventual move will be to the upside and we prefer a short duration posture. Inflation remains tame and signs of a pick-up are not yet appearing.
Weak and Strong U.S. Dollar
Premium yields were available in U.S. bonds until recently, and foreign buying added strength to the dollar. Now that U.S. yields are near zero this buying power may subside. However, the dollar remains the best safe haven in times of crisis, and this could generate demand regardless of rate spreads. We are neutral on the USD until one of these forces begins to dominate.
Domestic and International
International equities carry a normalized P/E ratio that is just two-thirds that of the U.S. market. However, it appears that the economic impact of the coronavirus will hit Europe harder than the U.S., even as China is beginning to rebound. We remind investors that an important historical trend to watch for is the potential for a U.S.-market selloff to flip investor preference from recent winners (domestic stocks) into a rotation toward international stocks once a global economic bottom is in sight.
Developed and Emerging
Emerging Markets had underperformed going into the bear market, and a global recession will certainly weigh on commodity and energy prices. Still, EM carries attractive valuations, and there is evidence that China’s economy may be the first to rebound from coronavirus woes. EM is one of the best plays on a weaker U.S. dollar, and we believe that is a useful portfolio attribute. We have increased our EM position to a slight overweight to reflect valuation and the global timing of the virus recession.
Value and Growth
The Value style is weighed down by exposures to Energy and Financials, the two sectors most severely impacted by global recession. In addition, cyclical companies face an undefined, lower bound as the global economy slows. Even though Value has become noticeably cheaper during the bear market, we are sticking with the top-line strength and cash flow generation of the Growth style. It is possible—perhaps likely—that leadership will shift to Value in a major market rebound, but that looks to be some time in coming. While we are intrigued by the valuations offered in cheaper segments of the market, we prefer Growth and High Quality.
Large and Small Cap
Small caps have declined more than large caps in the bear market, pushing valuations to very compelling levels. However, with 40% of the smallest companies (by market cap) losing money, we think there is significant risk of business failures across the cohort of unprofitable companies. Small caps are also more exposed to the business cycle, and a likely recession will pressure financial results. We have initiated a position in profitable small caps based on valuation but will wait for the economy to base before significantly adding to this position.
Defensive and Cyclical
Like Value, Cyclicals have become extremely cheap in this selloff, but they face more pressure from a weakened economy and potential balance sheet concerns. Growth and Quality have been consistent outperformers of late and we are overweight both; a low discount rate also benefits the Growth style over Value. However, the desire of equity investors to own safer assets has caused valuations of defensive stocks to remain high even though their growth rates are below average. We believe it will take a significant shift in market sentiment to knock Growth off its perch.
REITs: Negative and Positive
REITs are exposed to the consumer shutdown that is facing restaurants, retailers, and travel. The types of government relief that might be available to these businesses remains up in the air, yet we don’t see how closing the economy for a month or more will have anything but a serious negative impact on real estate. Businesses that make it through the recession in good shape will likely still be hesitant to commit to additional long-term lease obligations for some while.
Commodities: Negative and Positive
Industrial commodity prices have weakened as the global economy decelerates; a slowing of physical economic activity for a few months will limit demand for raw materials. Energy is locked in a price war that is rendering new domestic capacity uneconomic. We prefer to avoid commodities if business activity is shutting down.