SOLR - New Regime New Portfolio Approach

2023-04-17 10:30:00 ET

Summary

• The joint stock-bond rally this year has put renewed focus on portfolio construction approaches. We think a new macro regime needs a new approach.
• U.S. stocks rose last week but lost steam on Friday on the market partly pricing out potential rate cuts. We don’t see cuts this year as core inflation stays sticky.
• U.S. earnings results pick up this week and are overall expected to slump the most in three years. We don’t think that reflects the coming damage yet.

Transcript

A traditional portfolio of 60% stocks and 40% bonds in public indices is having a strong start to 2023 after its worst year in decades.

We don’t see this as the return of a sustained rally in stocks and bonds like we saw in the past four decades.

We’re in a volatile economic regime now, which we think warrants a new portfolio approach.

Here’s the ABCs we flag to investors on building portfolios:

1) Appeal of Income

Major central banks keeping policy rates higher-for-longer to curb persistent inflation enhances the appeal of income in short-term bonds.

2) Breaking up buckets

We think strategic views need to be more granular - across sectors and within private markets. On a tactical, six- to 12-month view, we prefer granularity in sectors like energy and healthcare, actively selecting companies with quality characteristics.

3) Coasting could prove costly

We think being more nimble with strategic allocations is important because coasting can prove costly. We also think tactical opportunities play a key role.

One example: We’re strategically overweight developed market equities but tactically underweight.

We think that getting the asset mix right in the new regime will be crucial for maximizing returns. This is even more important against a backdrop of structural forces like geopolitical tensions.

___________

Stocks and bonds have both rallied this year. Some see this as reason to return to traditional portfolio approaches like 60% stocks and 40% bonds. Those used to work when both assets trended up and bonds offset equity slides. We think a focus on any one asset allocation mix misses the point: a regime of higher volatility with sticky inflation needs a new approach to building tactical and strategic portfolios. We see the appeal of income, get more granular with views and are more nimble.

A new relationship

Notes: The chart shows the average daily return of 10-year U.S. Treasuries on days when equity prices fall. The yellow bars show these daily returns for the period 2000-2007 and 2008-2020. The red bar shows 2021 and onwards. All periods start in January and end in December for each respective range. The index used for equities is MSCI World.

An allocation based on the traditional investing approach of using broad, public indexes of 60% equity and 40% bonds is having a strong start to 2023 after the worst year in decades. We don’t see the return of a joint stock-bond bull market like we saw in the Great Moderation. That was a decades-long period of largely stable activity and inflation when most assets rallied and bonds provided diversification when stocks slumped. We think strategic allocations of five years and beyond built on these old assumptions do not reflect the new regime we’re in - one where major central banks are hiking interest rates into recession to try to bring inflation down. We find that bond returns provided reliable diversification for most of the Great Moderation, helping offset equity selloffs (yellow bars in chart). Some of that ballast has gone away. Average bond returns have dipped alongside equities since 2021 (orange bar) - but higher yields mean income is finally back in fixed income.

Our new approach

The merit of long-term bonds as portfolio diversifiers has fueled a debate over the future of the 60% stocks, 40% bonds portfolio. We think talking about numbers misses the point. The debate should be more about the approach to portfolio construction rather than the broad allocation levels. We believe in a new approach to building portfolios.

Our approach starts with income: the longer rates stay higher, the greater the appeal of income in short-term bonds. We see interest rates staying higher as the Federal Reserve seeks to curb sticky inflation - and we don’t see the Fed coming to the rescue by cutting rates or a return to a historically low interest rate environment. This reinforces the appeal of income in short-term paper. Yet, we also see long-term yields rising on both strategic and tactical horizons as investors demand more term premium, or compensation for holding long-term bonds in an environment of higher inflation and debt.

We are also breaking up traditional asset allocation buckets, moving away from broad allocations to public equities and bonds. We think strategic views need to be more granular - across sectors and within private markets - to help build more resilient portfolios in the new regime. On a tactical, six- to 12-month view, we prefer to get more granular by digging into sectors like energy and healthcare, actively selecting companies with quality characteristics: stronger earnings and cash flow that can better weather a recession, resilient supply chains, strong market share and the ability to pass on higher prices. Within fixed income, our granular approach aligns across tactical and strategic views. We’re overweight inflation-linked bonds on both horizons given our expectations of persistent inflation.

Why we stay nimble

We think being more nimble is key because coasting with strategic allocations can prove costly. It’s even more important against a backdrop of structural forces like geopolitical tensions, the energy transition and shifts driven by banking sector turmoil. We’re adjusting our strategic portfolios more frequently in response to new information and market shocks. One example: we’re strategically overweight developed market ((DM)) equities but tactically underweight. That’s because strategic investors are investing on a timeline where much of the short-term pain would be in the rear-view mirror - they can look ahead and seize opportunities now. We think that getting the asset mix right in the new regime will be crucial for maximizing returns: our work finds that getting it wrong could be up to three times greater the impact now than in the Great Moderation.

Bottom line: Our portfolio construction approach favors income while getting granular and more nimble in the new regime.

Market backdrop

U.S. stocks rose last week near 2023 highs but lost steam on Friday on the market partly pricing out potential rate cuts. The two-year U.S. Treasury yield swung back above 4.0% but remains well off the 16-year high from early March, driven by market hopes for rate cuts. The core U.S. CPI for March showed a resurgence in goods prices and persistent pressure from services. That means inflation is still not on track to fall near policy targets, in our view - so we don’t see rate cuts this year.

U.S. first-quarter earnings results pick up this week. A few big banks led the way last Friday, beating market expectations for profit. First-quarter earnings are expected to slump the most in three years - and for the second quarter in a row, FactSet data show. We don’t think that reflects the coming damage yet.

This post originally appeared on the iShares Market Insights.

For further details see: