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Vjosana Klosi, I’m a director in portfolio construction with CIBC Asset Management.
The current pandemic has resulted in the largest contraction in the world GDP since the Great Depression. Along with a projected 4.9 contraction in the world GDP by the IMF for the year, this crisis has brought about considerable volatility and uncertainty in the financial markets. This has further highlighted the benefits of developing a rigorous long-term asset allocation plan with a financial advisor who understands the main driving forces of the risk and return dynamics within the various asset classes.
Here I would like to cover some of the consensus post-pandemic themes from key market strategists that guide our strategic asset allocation work. A dominating theme in the current environment is that we’re seeing lower expected returns versus historical estimates for both equities and fixed income. Within the fixed income, the low level of interest rates implies lower long-term expected returns.
Given that yields don’t have room to be reduced further if there was a need to do so during a potential second downturn, the diversification benefits of bonds could prove to be limited. Despite lower expected returns and reduced diversification benefits, a strategic asset allocation to fixed income is still very consistent with our long-term investment belief.
To partially mitigate the volatility and uncertainty during the crisis in our fixed income allocations, we are recommending greater asset class diversification. This can be done through investments in actively managed higher-quality credit products or through multi-sector fixed income products.
The role of actively managed fixed income portfolios is of most importance during this time of post-crisis recovery. Actively managed portfolios are better positioned to manage the growing divergence in performance of sectors and countries based on the degree to which they’re impacted and are able to recover by the virus.
As part of our asset allocation proposals, we are also looking at allocations to liquid alternatives as a way to bring in further diversification and manage downside risk.
Another key theme within fixed income is that corporate and high-yield credit should provide a yield pickup over lower-yielding government bonds in many developed countries. And this is reflected in our higher long-term expected returns for high yields and corporate credit versus governments. The consensus view amongst strategists is that this is, however, expected to come with increased volatility. As such, it’s important to continue to be well diversified within the credit universe.
The third major theme is potential inflationary long-term risks with the outlook. Low inflation has been a key theme for years, and now we’re seeing increased consciousness amongst strategists for inflation being a long-term concern. The massive fiscal and monetary support by developed countries’ governments could result in increased inflation in the long term. 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, consensus estimates continue to favour international and Canadian equities versus U.S. equities, mainly based on persistent valuation gaps between U.S. and international markets before and after the pandemic. The current valuation levels in the U.S. are in the top 1% versus their historical levels. And that has brought a bit of concern with regards to U.S. valuations being high in the market.
In addition, emerging markets are expected to provide additional premium based on higher long-term growth prospects. Despite higher expected returns in the long run, the current crisis has brought about considerable divergence in the ability of regions and their associated governments to deal with the pandemic. As such, investments in emerging markets, while expected to provide a premium, should remain within considerable risk band.
The current environment of lower expected returns and higher volatility makes room for strategic allocations to private assets and alternatives as a way of providing further diversification and return potential in balanced portfolios. These are some of the key themes amongst strategists that are dominating the current low interest rate and high-valuation environment.