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4Q Outlook: Five portfolio construction themes
1. Overcome paralysis and take action
Capital markets volatility, worries about the coronavirus pandemic and uncertainty surrounding the U.S. elections are causing some to freeze, postpone rebalancing or make new allocations. Or, many investors are over-allocated to cash, reflecting fears that many areas of the market may be overvalued.
We think this is a mistake. Investors need some cash for current spending needs (and opportunistic buying), but we think most should remain fully invested and stick with their long-term investment and rebalancing plans. We offered some specific ideas earlier in our outlook, and the below themes carry those through.
2. It’s still all about income
For all investors, income generation remains a struggle. And, as Figure 5 showed, ultra-easy monetary policy means that’s not going to change any time soon. We suggest investors continue to consider different areas of the fixed income landscape, dividend-paying equities and alternatives such as real estate, real assets and private credit.
In casting this wider net, however, investors should understand which risks are entailed to generate more income and how these risks work together. We broadly categorize possible asset classes into buckets of interest rate risk, credit risk and equity risk. Each offers different yield and volatility profiles, and we suggest investors diversify across different income opportunities and risks, as shown in the figure below.
3. Pay attention to currency risks
Currency allocations are a growing risk, especially for multinational institutional investors for whom f/x moves may impact the growth of both assets and liabilities. Returns on private assets with long lockup periods can be greatly influenced by currency fluctuations. Currency hedges, however, are often too expensive to be worthwhile. So we think nearly all investors will have some unavoidable currency risk in their portfolios, and that’s not necessarily a bad thing.
In particular, we think the U.S. dollar is likely to weaken further, especially against emerging market currencies. This year, the dollar has weakened mainly against other developed market currencies like the euro and yen. However, it has yet to fall substantially against emerging markets f/x, which creates opportunities for local emerging markets debt investments. The dollar depreciation should also benefit emerging market equities.
4. Focus on fundamentals and relative value
At our most recent Global Investment Committee session, we carefully considered whether markets were becoming divorced from fundamentals. Our answer was no. While some areas appear fully valued, we think investors should focus on relative opportunities across and within asset classes.
Within equities, we favor higher quality growth, but also see select opportunities in value areas (especially outside of the U.S.). We also think the consumer sector looks attractive and dividend stocks look relatively cheap, especially in a low-yield world. Our fixed income views focus on higher quality, especially where spreads are narrow. Emerging markets debt looks particularly attractive, and we also favor the preferreds sector and structured assets. Additionally, we see opportunities across high grade and high yield municipal bonds, where we favor longer duration and more credit exposure. We specifically like “recovery stories” and see opportunities in airport and transportation bonds, and select names in the travel and leisure sector
We’re focused on alternative and niche real estate areas, such as single-family rental and medical office and lab space, as well as public and private industrial real estate benefiting from the increasing shift to e-commerce. On the public infrastructure side, we prefer electric utilities and technology over passenger transportation and midstream energy. And we see many opportunities across private real assets, including farmland, renewables and digital infrastructure.
And as a critical final point: Across all asset classes, we think investors should continue to focus on environmental, social and governance factors. ESG considerations can potentially help portfolios generate additional returns, help manage risk and increase portfolio efficiency.
5. Stay flexible and nimble amid volatility
We expect volatility to remain elevated and long-term returns across asset classes to remain challenged. This speaks to the importance of selectivity and the ability to shift allocations as opportunities arise – in other words, focusing on active management. Across asset classes, all members of our Global Investment Committee and portfolio management teams are finding investment ideas that are highly idiosyncratic and fast moving. Selectivity, research, nimbleness and confidence all continue to matter.
All market and economic data from Bloomberg, FactSet and Morningstar.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature.
Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Alerian MLP Index is the leading gauge of energy Master Limited Partnerships (MLPs). The float-adjusted, capitalization-weighted index, whose constituents represent approximately 85% of total float-adjusted market capitalization, is disseminated in real-time on a price-return basis (AMZ) and on a total-return basis (AMZX). Bloomberg Barclays High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds. Bloomberg Barclays Corporate High Yield 2% Issuer Capped Index measures the USD-denominated, highyield, fixed-rate corporate bond market and limits each issuer to 2% of the index. Bloomberg Barclays Municipal Bond Index covers the USD denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and prerefunded bonds. Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency) Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers. Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Index tracks agency mortgage-backed passthrough securities. Bloomberg Barclays U.S. TIPS Index is an unmanaged index that includes all publicly issued, U.S. Treasury inflation-protected securities that have at least one year remaining to maturity, are rated investment grade, and have $250 million or more of outstanding face value. Cliffwater Direct Lending Index (CDLI) seeks to measure the unlevered, gross of fee performance of U.S. middle market corporate loans, as represented by the asset-weighted performance of the underlying assets of Business Development Companies. Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the $US-denominated leveraged loan market. ICE BofA Preferred Stock Fixed Rate Index is designed to replicate the total return of a diversified group of investment-grade preferred securities. S&P Global Infrastructure Index is designed to track 75 companies from around the world chosen to represent the listed infrastructure industry while maintaining liquidity and tradability. To create diversified exposure, the index includes three distinct infrastructure clusters: energy, transportation, and utilities. JPMorgan Emerging Market Bond Index tracks the performance of bonds issued by developing countries. MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. MSCI US REIT Index is a free float-adjusted market capitalization weighted index that is comprised of Equity REIT securities. The MSCI US REIT Index includes securities with exposure to core real estate (e.g. residential and retail properties) as well as securities with exposure to other types of real estate (e.g. casinos, theaters). MSCI World High Dividend Yield Index targets companies with high dividend income and quality characteristics and includes companies that have higher than average dividend yields that are both sustainable and persistent. NCREIF Property Index is a quarterly time series composite total rate of return measure of investment performance of a very large pool of individual commercial real estate properties acquired in the private market for investment purposes only. S&P 500 Index is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization. S&P U.S. Treasury Bond 1-3 Year Index is designed to measure the performance of U.S. Treasury bonds maturing in 1 to 3 years. S&P U.S. Treasury Bond 7-10 Year Index is designed to measure the performance of U.S. Treasury bonds maturing in 7 to 10 years.
A word on risk
All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investing involves risk. Investments are also subject to political, currency and regulatory risks. These risks may be magnified in emerging markets. Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Credit ratings are subject to change. AAA, AA, A, and BBB are investment grade ratings; BB, B, CCC/CC/C and D are below-investment grade ratings. As an asset class, real assets are less developed, more illiquid, and less transparent compared to traditional asset classes. Investments will be subject to risks generally associated with the ownership of real estate-related assets and foreign investing, including changes in economic conditions, currency values, environmental risks, the cost of and ability to obtain insurance, and risks related to leasing of properties. Socially Responsible Investments are subject to Social Criteria Risk, namely the risk that because social criteria exclude securities of certain issuers for non-financial reasons, investors may forgo some market opportunities available to those that don’t use these criteria. Investors should be aware that alternative investments including private equity and private debt are speculative, subject to substantial risks including the risks associated with limited liquidity, the use of leverage, short sales and concentrated investments and may involve complex tax structures and investment strategies. Alternative investments may be illiquid, there may be no liquid secondary market or ready purchasers for such securities, they may not be required to provide periodic pricing or valuation information to investors, there may be delays in distributing tax information to investors, they are not subject to the same regulatory requirements as other types of pooled investment vehicles, and they may be subject to high fees and expenses, which will reduce profits. Alternative investments are not appropriate for all investors and should not constitute an entire investment program. Investors may lose all or substantially all of the capital invested. The historical returns achieved by alternative asset vehicles is not a prediction of future performance or a guarantee of future results, and there can be no assurance that comparable returns will be achieved by any strategy.
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