An economic recovery is temporary, by definition, with differing opinions the pulse of investor opportunity. Portfolios must reflect forward-looking realities, with several developments of note.
Recoveries, by definition, are transitory. This is true whether we're talking about an economic recovery, a stock market recovery or an injury recovery. They consist of a period of time following a setback, with an opportunity to see faster improvements than during a normal expansionary phase. This is not guaranteed, of course, as any athlete with hamstring problems can attest. Or if you grew up in 1990s Japan, where the "recovery" is arguably still going, beset with countless setbacks.
But they do eventually end, by definition. At some point, it stops being a recovery and it becomes the start of a new expansionary phase, at least until the next setback occurs. Yet, recoveries do represent an outstanding period of time for investors, with a desirable blend of positive data flow, fast growing earnings and the return of once fearful investors. It can be a period where all ships rise as the tide changes, creating a cyclical upswing.
Turning to today, most of the cyclical upswing may now be behind us, although we continue to see positives. The key now is to stay a step ahead of the pack, knowing what may come as the recovery matures, ultimately positioning portfolios in a way that reflects forward-looking realities.
Our Take on Today's Economic Recovery
The economic recovery has been unique and powerful. The supportive environment is evolving quickly since the economy bottomed in mid-2020, with a stellar recovery in both the economy and markets. Perhaps so strong that it is no longer valid to call it a recovery. We've seen economic activity revert back towards pre-pandemic levels and wage inflation is rising.
From an investor's perspective, we saw the classic recovery plot, with equity investors front-running the economic recovery (the price-to-earnings ratio expanded) before corporate earnings picked up and took the driver's seat (as earnings accelerated, the P/E ratio deflated). In our multi-asset portfolios, we were thankful to see some valuation opportunities early and took advantage of the cyclical upswing.
In a forward-looking sense, many market participants are still encouraged by the economic recovery, with strong corporate earnings and cheap interest rates, so continue investing full throttle. Others are beginning to question the durability of the recovery. We'd just comment that this type of bifurcation among market participants is very normal at this stage of a recovery, as economic maturity increases, and the positive dataflow somewhat softens. In this regard, we are broadly positioned for a continuation of the economic recovery, even as we've paired back some of the cyclical positioning.
What are the Key Positions in Our Portfolios?
The key question we ask ourselves is what positions will best help investors reach their goals? This is the task (and opportunity) faced by our investment team. To summarise a few major positioning points:
- We are relatively balanced in our broader risk assessment, taking a modestly protective stance, acknowledging the strong run in markets and some fundamental risks ahead. We are offsetting some of our cyclical risk with exposure to defensive sectors like consumer staples and healthcare, based on our valuation work.
- In equities, we have broadened out our value-oriented holdings with key positions in energy and financial companies, which makes sense to us for most economic pathways. That said, exposure to value stocks remains among the largest relative driver of our portfolios at the current time. In our multi-asset portfolios, we carry a U.S. equity underweight too. This is offset by healthy exposure to the UK, Japan, and emerging markets. We have also introduced exposure to China in growth-oriented portfolios, against a tide of negative sentiment.
- For portfolios with fixed income exposure, we favour emerging market debt in local currency. Elsewhere, our analysis still shows that many fixed income markets are expensive, especially so in high yield corporate bonds, where we have shifted to an underweight position. In fixed income, we are balancing defensive characteristics against low absolute yields, generally preferring shorter-dated bonds.
- Our underlying currency positioning depends on the portfolio in question. For more conservative portfolios, we carry a home bias, but as we get into portfolios with more equity, we carry a range of currency exposures, including the Japanese Yen, which tends to behave as a safe haven currency in periods of broad market stress.
To capitalise on the broader recovery story, it is important to play through the probable economic pathways from here to determine how our positioning might fare. The first, and perhaps most likely scenario, is that the economic recovery is set to morph into a new economic expansion, despite some obvious headwinds.
If such a scenario transpired, our analysis suggests that in previous recoveries from global recessions, value outperformed growth more significantly. This might suggest there is still room for value stocks to outperform, as depicted in Exhibit 1.
One of the interesting gaps is the continued underperformance of value stocks.
Post-Recession Recovery: Historical Versus Post-Covid
Source: Morningstar Investment Management calculation, FactSet data, as at 31 August 2021. For illustrative purposes only. Past performance is not indicative of future results.
Others pathway that we must face up to include fundamental risks that are unique to this recovery. Prominently, a key risk is that this recovery was an expensive one. With both federal government and central bank support in the trillions globally, we averted a major economic crisis, yet the policy exit is fraught with danger. We further acknowledge some other key downside risks, including:
- Covid variants.
- Corporate capital supply. The ease by which companies can access capital via equity raisings is a potentially worrying development (from venture capital to SPACs and IPOs).
- High valuations. The COVID sell-off was short-lived, and the market was arguably overpriced going into the correction.
Some of these points have garnered mainstream coverage already, and we're not breaking new ground on these topics in this piece. Suffice to say there are "known unknowable's", with each development having widespread probabilities attached to it. It is for this exact reason we continue to diversify the risk drivers in our portfolios, so we are positioned for investor success in many outcomes, not just one.
Investors ought to be happy right now. For the vast majority of investors, we've experienced a tailwind of strong absolute performance related to the economic recovery. We should all be thankful for that, in what is proving to be a complex environment.
However, looking backwards isn't overly helpful for portfolio construction. So, across the portfolios we manage, we continue to spend the majority of our time living in the future—understanding fundamental risks, finding opportunities, then packaging it together into portfolio solutions that help investors reach their goals.
We won't get everything right, as no one carries a 100% strike rate, but investors can take comfort when our positioning reflects our best research. So, even when this economic recovery ends, which it will by definition, we are well equipped to empower investor success.
Since its original publication, this piece may have been edited to reflect the regulatory requirements of regions outside of the country it was originally published in.
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