How to invest in a world recovering from a pandemic, the risk that bonds could cause imbalances in portfolios and the possibility that the dollar is in a for a sustained fall are just some of the market concerns Rathbones is focusing on in its asset allocation.
With markets appearing to go through a series of rotations as investors look to a world where economies can restart, Rathbones highlights five key issues that are shaping its current investment strategy.
Risk and opportunities during the Covid recovery
The first issue is how investors are approaching the expected Covid-19 recovery.
Since the rollout of several effective Covid-19 vaccines began, investors have been shifting their portfolios out of the so-called ‘pandemic winners’ and into cheaper value stocks, which had been lagging prior to the vaccine but are expected to rebound during the recovery.
However, Rathbones thinks investors shouldn’t go so hard on either growth or value but should look for companies in the middle ground between the two.
“We believe it makes sense to reduce exposure to the most expensive growth stocks, while sticking with quality factors found in some cyclical companies that fall in the middle of the growth-value spectrum,” its strategists said.
This is because they think that the expectations for a rebound in the earnings of these struggling value stocks might be “too optimistic”.
Using the US as an example, the S&P 500 earnings forecast for 2021 shows that some cyclical sectors, such as energy and industrials, look set to rebound strongly. But other sectors might not reap the same rewards, such as financial, healthcare or real estate, which may actually get worse.
On the growth side, Rathbones analysed a ‘working from home’ basket of stocks, or 15 companies in the S&P 500 which have benefited from the stay-at-home order. These include video conferencing platforms, cloud hosting firms and electronic document signing businesses.
According to Rathbones, this group of companies have doubled its returns in the past year.
Rathbones said: “We still think it make sense for investors to keep a bias toward companies with a track record of strong growth. However, the advent of effective vaccines means a more balanced stance is now warranted. That means looking for quality companies that have cyclical characteristics and are reasonably priced.”
Emerging markets placed at the back of the vaccine queue
As mentioned above, there has been as rapid vaccine rollout over the past several months. But it would be more accurate to say that this has largely taken place in developed countries.
There have been growing concerns that developing and emerging markets (EM) have been left behind in the Covid-19 vaccine plan.
The World Health Organisation (WHO) recently made a statement on its concerns about the disproportionate vaccine distribution among richer and poorer countries.
Some emerging markets are countries that have already struggled to keep the Covid-19 virus under control and the barriers to vaccines could have further implications for the recovery of their markets and economies.
In its analysis of asset classes performance in 2021’s first quarter, Rathbones found countries that managed the Covid outbreak better, such as China, Thailand and Singapore, have already seen a market and economic recovery.
In contrast they found that many Latin American countries, which are struggling to control cases, are consequently seeing a negative and disruptive economic impact.
Rathbones said: “These developing countries are likely to take longer to control the virus and allow households and businesses to live and operate normally.
“As richer nations shake off the pandemic, the economic recovery will also probably start pushing interest rates slightly higher, which will have a knock-on effect on emerging economies.”
Bonds and low yields
The third issue the state of bond yields, specifically the government bonds sitting on negative yields.
The bond market went through an intense sell-off earlier this year when yields actually rose to above 1 per cent as investors priced in higher inflation during the expected Covid recovery. However, yields overall remain historically low despite the recent spike.
Rathbones said: “The historically negative correlation between equity and bond returns has also become less reliable in the current era of ultra-low interest rates and bond yields.”
“Rather than focus just on relative or potential returns, we believe portfolios should also be built around risk protection. To do that, we divide assets into three building blocks, which play different roles — liquidity (mostly safe-haven government bonds and cash), equity-type assets and diversifiers.
“We believe high-quality corporate bonds may be the best current substitute for government bonds in the L bucket. And using a combination of ‘LED’ assets allows us to construct a portfolio which will provide more attractive risk/return metrics than the classic portfolio with a 60-40 balance of government bonds and equities.”
A weakening US dollar
The penultimate risk is the US dollar, which Rathbones said “looks like it may be flying too high against most major currencies on a longer-term basis”.
According to the fund house, the greenback “looks vulnerable to a more sustained fall given it is trading at historically high levels on a trade basis and is also above our own measure of its long-term equilibrium value”.
It added that there were some tailwinds which over the next few months could go against that forecast.
Rathbones said: “There are a large amount of speculative short-term positions against the dollar (shorts). Rising US real yields could lead to significant dollar buying if a lot of these short positions are unwound as a consequence.”
But it added that there are headwinds as well though, namely the amount of stock held in dollar-denominated assets overseas and “a change in hedging mindset” could weaken the dollar.
“If vaccines are successful, global GDP could rise relative to the US and the growth advantage supporting the dollar could fade,” the firm’s strategists added.
The fund house said: “If our longer-term forecasts for a weaker dollar and stronger pound come to fruition, they could subtract from returns for global investors based in the UK when translated back to their home currency.”
Caution needed in active vs passive debate
The final issue is the ongoing active versus passive battle.
Over the past year, passive funds have attracted consistent inflows while investors have been pulling money out of active portfolios, according to the Calastone Fund Flows Index (FFI).
With markets being extremely volatile over the past year, Rathbones said this could have provided active managers “an opportunity to show how their asset allocation and stock picking expertise can generate outperformance”.
This isn’t always the case, as the group highlighted that investors holding a FTSE 250 tracker over 10 years would have outperformed other UK sectors and indices.
Performance of IA UK All Companies vs UK indices over 10yrs
Source: FE Analytics
However, the firm added that “this doesn’t tell the whole story” as active managers can offer greater exposure to less-researched smaller companies that have a greater potential for outperformance but a greater risk of falling harder during times of market stress.
“Active investing is generally a long-term exercise,” Rathbones finished.
“Looking at performance during recent market rebounds (April to November 2020, and the rebounds of 2019 and 2017) suggests active managers rebound more sharply than the market. However, reviewing performance this way has its flaws — it’s backward looking and subject to survivorship bias.
“For some investors, active approaches have been more palatable because their collective returns have had better risk-adjusted returns, while also outperforming the broader FTSE All Share index and FTSE 100.”
“Overall, a measured approach is needed when investing in UK equities, actively or passively.”