With economic uncertainty weighing on financial market performance, investors are considering how best to position their portfolios.
Earlier this year, the International Monetary Fund forecast global GDP to contract by nearly 5% in 2020. While Fitch Ratings more recently projected less damage — a contraction of 4.4% — based on the swift recovery since the spring’s shutdowns, it said it expected the recovery pace to slow from here.
With the pandemic resulting in considerable uncertainty and volatility in the financial markets, investors require “rigorous” long-term asset allocation plans, said Vjosana Klosi, director of portfolio construction at CIBC Asset Management, in a Sept. 23 interview.
To create those plans, financial advisors must understand the “driving forces of the risk-and-return dynamics within the various asset classes,” she said.
Klosi outlined some of those forces.
“A dominating theme in the current environment is that we’re seeing lower expected returns versus historical estimates for both equities and fixed income,” she said.
In fixed income, lower long-term returns are attributable to low interest rates.
Further, given that rates are already at or near zero around the world, central banks can’t materially reduce them during a potential second downturn. As a result, “the diversification benefits of bonds could prove to be limited,” Klosi said.
Faced with lower expected returns and reduced diversification benefits, Klosi recommended strategic allocations to fixed income.
Specifically, “we are recommending greater asset class diversification … through investments in actively managed higher-quality credit or multi-sector products,” she said.
Liquid alternatives can also improve diversification and manage downside risk in fixed income, she added.
Active management in the asset class is particularly important during the post-crisis recovery to better manage the growing divergence in performance among sectors and countries, Klosi said.
She also noted that corporate and high-yield credit should provide more yield pickup relative to lower-yielding government bonds in many developed countries — though she added a caveat.
“The consensus view amongst strategists is that this is, however, expected to come with increased volatility,” Klosi said. “As such, it’s important to continue to be well diversified within the credit universe.”
Another force in play is inflationary risk.
“The massive fiscal and monetary support by developed countries’ governments could result in increased inflation in the long term,” Klosi said.
“As such, a greater focus on inflation-mitigating strategies, such as real return bonds and commodities, might be appropriate in the long term once we see the economy has started to stabilize.”
Within equities, Klosi said Canadian and international stocks are favoured relative to U.S. ones based on a persistent valuation gap. “Current valuation levels in the U.S. are in the top 1% versus their historical levels,” she said.
Emerging markets stocks are generally expected to provide additional premium based on higher long-term growth prospects. However, those markets vary in how well they’re addressing the pandemic, so investors who choose emerging markets should have the appropriate risk profile, Klosi said.
Also within equities, strategic allocations to private assets and other alternatives are another option to address returns and diversification in balanced portfolios, she said.
This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.