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Investment strategy
July 21, 2021
6 mins

Equity portfolios should reflect an evolving economic cycle

July 21, 2021
6 mins
Steven Wieting
Chief Investment Strategist & Chief Economist
SUMMARY

There are increased near-term market risks related to global COVID-19 variants and the course of the pandemic. We believe the composition of global equity portfolios should reflect an evolving economic cycle.


The Global Investment Committee (GIC) left our allocation to Equities and Fixed Income unchanged. However, we made several changes within the composition of our global equity portfolios to reflect an evolving economic cycle. We see increased near-term market risks related from variants and the course of the pandemic. However, our changes today continue a set of long-planned steps aimed at increasing our exposure to sustainable long term returns and de-emphasizing assets merely rebounding from the shock of 2020.

Today's moves include upgrading allocations to large cap US equities and China at the expense of other emerging markets and real estate. We also now recommend holding 10% of medium-risk portfolios in equities that demonstrate consistent dividend growth, split between the US and non-US. This move does not raise the overall equity allocation, but raises the credit quality and income characteristics of the equity portfolio. The allocation to Global Equities remains 8% overweight. The allocation to global Fixed Income and Cash is 8% underweight.

Eliminating overweight

Today, we eliminated our thematic overweight to global REITS after a full recovery during the past 16 months. We do not expect negative returns for the asset class, but yields of 3% may represent the larger part of return in the coming year. A strong dispersion of performance between urban commercial real estate and ex urban housing should remain, with both unlikely to outperform global equities at the same time.

Growth opportunities in e-commerce, technology and health care real estate assets are notable, but these are not representative of global real estate as a whole. We would note that Real Estate remains a fully-allocated sector within large cap equities after removing our overweight (first added in June 2020).

We also eliminated our overweight in Latin American equities, but continue to expect economic recovery in the region in coming years. The allocation with the largest overweight in Brazil-has returned 63% in US dollar terms since we added our overweight in April 2020. The composition of Latam's markets - with a heavy skew to energy and other commodities - typically shows slow, volatile growth after large cyclical rebounds. While we believe near-term US monetary policy developments support the region, this will gradually move to a less accommodative posture in coming years.

In a positive light, we see Latin America's fundamentals mostly impaired by COVID rather than unorthodox policies and debt. However, we still see the future outlook for Fed policy impacting those emerging markets most dependent on international financing. With a neutral allocation to Latam, our allocation to the most leveraged EMs in Europe, the Middle East and Africa is underweight.

US and China

Today, we upgraded US large cap equities apart from Healthcare (our largest thematic overweight). US large caps shows sustainable growth opportunities even at a higher-than average valuation. US dividend growth has compounded at 6% over the past 20 years vs 3% in Europe, explaining the large valuation gap between the two regions. The US and China markets both offer technological solutions that are rising as shares of the economy and profits. Our US large cap overweight now offsets our underweight in SMID, which we held as an overweight during the majority of the past 16 months.

Since we lowered our weighting in China in late January, China's equities have underperformed the global equity market by 23 percentage points. China shares are one of the few larger global equity markets posting a negative return in 2021. We believe this has been driven by credit tightening measures and regulatory changes that are becoming either fully embedded in valuations or are set to reverse. The growth slowdown and credit market disruptions in China can both be traced to deliberate policy actions that we believe China will conclude.

China equities trade at 14X trailing earnings, with local tech shares having fallen far more than US shares. The recent stronger credit tend and cut to reserve ratio requirements typically reflect a broader change in macro-economic policy away from growth restraint (please our Asia Strategist for full discussion).

Long-term interest rate trends in the US also influence our view of US growth stock valuations. Despite falling 50 basis points from the high of 2021, US 10-year Treasury yields are at a slight premium to global bond yields that include sub-investment grade and emerging markets debt.

While we don't expect long-term yields to keep falling in coming quarters, a rebound in rates driven by policy tightening will likely come somewhat later than we expected, at a more advanced stage of business cycle recovery. Even if this delay is marginal (6 months or less), it would come at a risker time, restraining the level of yields.

Many developments suggest long-term rates will struggle to reach our earlier assumptions in the coming year. Nonetheless, with 10-year yields a full percentage point below 10-year average estimated inflation most global bonds remain unappealing. At the low end of the risk spectrum, we overweight Treasury Inflation Protected Securities. At the higher end of the risk spectrum, we overweight variable rate US loans. We express the majority our global bond underweight through European and Japanese government bonds.

Fastest pace of economic rebound to soon pass

As we discussed in last month's Quadrant, the fastest pace of economic rebound will likely soon pass. This has sent yields lower, prior to troubling COVID developments of the past two weeks.

We have always expected variants to pose challenges requiring adaptive vaccines in the coming year. However surprise has been the very sharp rise in national cases in the second most vaccinated large country, the UK. This suggests the strong potential for a rise in infections globally among the unvaccinated in the coming few months. At the same time, the path of infections in India in the late spring suggests this could be very severe but short in duration as the so-called delta variant spreads rapidly.

We would view another wave of global COVID infections as a "disappointment” likely to slow the pace of global reopening rather than a "shock." The surprise factor in play in early 2020 is absent, and industries are not positioned with the same level of vulnerability.

Most goods-producing industries are constrained by lack of supplies amid excess demand. A cooling will not cause another plunge in global production or trade. Household balance sheets in developed economies are very strongly positioned to sustain growth. On the other hand, economic vulnerabilities are acute in global travel and hospitality which will delay economic recovery in some smaller tourism-driven economies.

With this said, asset prices have also evolved since the initial COVID shock. While world markets may resist a severe setback from a new COVID wave, most assets have recovered sharply from 2020 loses. While some pockets of distressed values remain, as we discussed in our Mid-Year Outlook, we believe “mean reversion” opportunities are diminishing. In a period of more moderate gains, we have shifted allocations toward sustainable return generators such as dividend growth strategies.

In the past 30 years, US firms with the most consistent dividend growth have outperformed the S&P 500 by 60 percentage points. In each of the 5 years of annual equity market loses, these firms have seen shares fall by less than markets as a whole. Lower quality firms typically post larger gains after crisis periods but lag in sustained recoveries. Our allocations are shifting to reflect this maturation of the recovery cycle.

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