With equities no longer the only game in town and free money perhaps something of the past, asset allocation has become so much more complicated and a somewhat fascinating puzzle to solve.
With the dislocation present in equity markets from a regional as well as sector perspective – where could money be made in the next decade? Because starting yields from fixed income assets today are much higher, could one argue that bonds have more roles to play today than the traditional uncorrelated nature to equities? How do you construct a portfolio to ensure robustness against a world of glaring problems and how do you ensure a real return for clients given much higher inflation these days?
It was my privilege to unpack some of these very relevant questions at the Morningstar Investment Conference South Africa (MICSA), held on 20 September in Johannesburg. I was joined by panellists James Bullock (Portfolio Manager at Lindsell Train), Gurpreet Gill (Macro Strategist at Goldman Sachs Asset Management) and Sean Neethling (Head of Investments S.A. at Morningstar South Africa).
The session shared insights into the pockets of value from global equity and fixed income markets, and the combination thereof in a multi-asset portfolio. I highlight some key take-outs from this session in the following paragraphs.
Making sense of the macro environment
Investors came into 2023 on high alert for a potential recession. The reality is that if we are in a recession, it is a pretty strange one. The US treasury yield curve is still deeply inverted, but pockets of the US economy remain very buoyant and consumer spending keeps on surprising on the upside. Inflation is moderating, but the Federal Reserve Bank’s tone continues to be hawkish. In addition, most companies on the S&P 500 have beaten profit expectations (thus far). All of the latter combine to ensure a fairly complex macro backdrop.
According to Gurpreet Gill, Goldman Sachs still believes the US is on course for a soft landing and the Fed won’t cut interest rates unless there is clear evidence that inflation is under control.
It’s a strange strange world we live in
One can’t deny that one of the fastest-rate hiking cycles in history has some noteworthy implications for markets – for both fixed income and from an equity perspective.
Gill further added that Goldman Sachs is of the view that a wave of defaults in US High Yield debt is unlikely compared to previous default cycles. Gill further stated that they believe credit is of much higher quality today than it was in the past.
The reason for this is two-fold. With the pandemic shock in 2020, there has been a wave of fallen angels from investment-grade companies that entered high yield. The second reason is that there has already been a default cycle a couple of years ago. One can also argue that most companies in the US entered this environment from a position of strength. It is however important to take into consideration that fixed-income instruments may behave more like equities in volatile and uncertain environments. It, therefore, remains imperative to assess every opportunity on a bottom-up basis and consider the role it plays in a client’s multi-asset portfolio.
From an equity perspective, 2023 has been all about US Tech – Artificial Intelligence (AI) in particular. Most of the gains (to date) in the US market have been driven by a very narrow set of companies. This results in an overconcentration of the index and it potentially exposes investors to very significant downside risk.
US valuations are lofty but pockets of opportunity remain
With US Tech valuations being on the lofty side, fund managers must hunt elsewhere to ensure that client portfolios are exposed to areas that are more attractive on a relative basis.
According to James Bullock, Lindsell Train is still finding plenty of opportunities outside of the US tech complex – particularly in markets like the UK or Japan. There are still plenty of high-quality companies with strong balance sheets and heritage brands that can compound growth for investors over meaningful periods of time. Lindsell Train is also very bullish on video games as a sector as well as consumer defensive stocks. Lindsell Train also gets emerging market exposure indirectly through companies that generate earnings from markets like India for example.
According to Sean Neethling from Morningstar Investment Management South Africa, Morningstar’s global portfolios are also underweight US equities and US tech. Implied returns are below levels investors should be earning to adequately compensate them for the range of potential outcomes in a volatile market, hinging on the growth prospects of high-quality but exceedingly complex and expensively priced businesses.
From a Morningstar perspective, emerging markets remain an interesting opportunity, bearing in mind that emerging markets are not a homogenous group of shares with the same alpha drivers. China’s latest economic weakness has spooked markets, with a stream of media coverage about deflation and property developers collapsing. According to Neethling, the case for exposure to China remains intact and is supported by sensible sizing across Morningstar’s most aggressive S.A. global and local mandates. Brazil is another opportunity that Morningstar continues to hold in portfolios and it has served clients well.
Should one be dialing risk up or down in portfolios at this point in time?
The panel consensus was neither. At Morningstar, we don’t believe that investors are being adequately compensated for taking on additional levels of risk today. Even though there are pockets of opportunity and one could build portfolios that are differentiated, we would not be advocating for increasing risk at a total portfolio level at this point in time.
More could go wrong than what potentially will go wrong. There are a lot of very visible risks across the globe at the moment and, understandably, investors are feeling very nervous. Despite this, global equity and fixed income managers today are cautiously optimistic about the long-term prospects of opportunities presenting themselves.
Having a disciplined and robust investment process with a strong focus on valuation and position sizing helps us navigate these uncertain waters. Investors must make sure they are in the right type of strategy to be able to stomach an environment with a high degree of uncertainty and a wide range of outcomes.
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