The flexibility to navigate unpredictable markets

Written By: Suzanne Hutchin Portfolio Manager, Real Return Team Newton Investment Management

Suzanne Hutchins of Newton Investment Management explains why a flexible approach to asset allocation, with the ability to respond swiftly to challenges along the way, could be critical in generating credible long-term absolute returns

As the Covid-19 crisis has unfolded, one of the key themes emerging is the “tug of war” that has developed between inflationary and deflationary forces. On the deflationary side, the massive collapse in private sector-generated cash flow and incomes since the introduction of lockdowns will lead to significant deleveraging as debt burdens become too large for many businesses to manage. Conversely, the unprecedented policy response, with public-sector balance sheets expanding to new levels, represents an inflationary influence which seeks to limit the fallout from the crisis.

Based on financial-market price action since late March, it is tempting to conclude that the reflationary forces are winning. However, it is premature to declare the battle has been won, as several material risks to the economic outlook remain. More fragile businesses are failing, and there will be job losses as a result. Recessions have also traditionally provided a good excuse for companies to “trim the fat”, and government furlough schemes are likely to have only deferred the timing of some redundancies, while many businesses may look to cut capital expenditure. Furthermore, although restrictions on economic and social life are now being eased, until a vaccine is found for the virus, there will be restrictions and costs of doing business that did not exist before.

The very nature of the current recession, which was initiated by a state-imposed collapse in activity, makes the outlook that much more uncertain. One scenario is that, as restrictions on economic and social activity are lifted, economies will bounce back quickly. However, there are clear signs that damage has already been done to economies. In addition, further damage is possible as policy support is reduced and if the virus resurges in a “second wave”.

Moreover, as we have learnt over the post-financial crisis period, monetary easing has a much greater impact on financial-market prices than it does on the non-financial economy. While fiscal policy is playing a much greater part in the policy response to the Covid-19 crisis than it did during the 2007-08 global financial crisis, monetary easing has continued to dominate, with risk assets sustaining a broadly upward trajectory. Should the recovery in the non-financial economy be slow, or undercut by a resurgence of the virus, nominal cash flows and earnings will not recover, which could leave valuations for risk assets elevated and exposed. Against this background, investors will require the flexibility to respond to a wide range of potential outcomes.

Structural shift in the inflationary environment?
For over a decade our thematic framework – and specifically our state intervention theme – has highlighted how authorities have engaged in ever-greater policy intervention and regulation to shore up economic growth. We have long held the view that monetary policy would be unsuccessful in returning nominal growth rates to the levels they were at prior to the 2007-08 financial crisis, owing to structural and cyclical factors, and had anticipated that the perceived solution to low nominal growth would be the unification of monetary and fiscal policy. We also expected that it would take a crisis in order to catalyse this transition, since fiscal policy, which necessitates an increased role for governments, marks a break from the policy orthodoxy of “free markets”. The Covid-19 pandemic now looks to be that crisis.

Government fiscal deficits have trended steadily larger since the end of the Bretton Woods system of monetary management in 1971, when the US announced that it would no longer exchange gold for dollars. While fiscal policy has mainly been counter-cyclical during this period, in recent years larger government deficits have not been restricted to economic downturns. Now, in the wake of Covid-19, the remnants of any pretence of a link between government revenues and spending has been abandoned. “Modern Monetary Theory” (MMT) has been put forward as the intellectual justification for the monetary financing of fiscal deficits. Should such policies be widely implemented by governments around the world, we could be in the foothills of a new inflationary era, which would lead to major changes in many financial-market trends.

To be specific, if inflation returns with any vigour it could materially undermine returns from a wide variety of fixed- income strategies given the low yields available. Well-judged timing to reduce a strategic allocation to fixed income will be important to preserve capital.

The benefits of a flexible, diversified approach
In this uncertain environment, we believe there is a strong case for investment strategies which focus on the diversification of asset types and uncorrelated return streams, and which have the flexibility to adjust positioning both strategically and tactically (even overnight) to reflect the changing economic circumstances. A strategy that aims to create an asymmetric return profile can seek to deliver strong risk-adjusted returns by using a globally diversified portfolio to balance growth with capital protection. In fixed income for example, the recovery in investment-grade credit has been much faster than in 2009 as central banks have this time been more coordinated and faster to act. However, at the same time, the fundamentals are mixed and the full effect of the crisis on issuers is still to be revealed. We expect to see a continued increase in the number of “fallen angels” (investment-grade issuers downgraded to high yield) throughout this year, as well as general downward rating migration for the more challenged business models. Nevertheless, with dispersion between industry sectors remaining high, there is still an opportunity to add value through active credit selection. When considering allocations to equities, an approach that is unconstrained in terms of its asset allocation can, to a significant degree, step away from the asset class if the near-term prospects seem poor. However, it is important to note that global equities are not a homogenous asset class, and one of the consequences of the pandemic has been to catalyse a significant bifurcation between the “winners” and “losers”, which means that there is the potential to unlock improved outcomes through stock selection.

During the current crisis, more economically sensitive companies (many of which had already been under pressure for much of 2019), as well as those dependent upon “normal” patterns of human activity, have lagged. Undoubtedly many of these companies are beset with structural and balance- sheet issues that are likely to render them poor long-term investments. Nevertheless, it feels as though a few babies have been thrown out with the bathwater. In all but the most negative public health and economic scenarios, such situations appear to us to represent the best hunting ground for opportunities at the present time, although clearly it is vital to be highly selective. In this vein, adding to companies in areas such as mining, industrials and insurance, can help achieve a balance alongside strategic positions in sectors such as health care, technology and branded consumer exposures.

Building a return profile
A multi-asset strategy can build its return profile by drawing on the different characteristics of the return-seeking securities that it invests in. Through a business cycle, stabilising or hedging assets can offer the prospect of a lower but still positive annual return, while tactical asset-allocation flexibility can also have the potential to contribute positively. In aggregate, these elements seek to provide a respectable return profile in a very low-yield world.

While policymakers’ unparalleled attempts to stimulate economies via both monetary and fiscal means appear likely to keep the party going for now, the many unknowns that exist around the shape of any recovery from the pandemic and associated economic disruption mean that markets are likely to remain highly volatile. A flexible approach to asset allocation offers the ability to be nimble and respond to surprises. Such a focus could be valuable for portfolios as both a stabilising element and a diversifier, without forgoing the possibility of participating in capital growth.

Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.

This is a financial promotion. These opinions should not be construed as investment or any other advice and are subject to change. This article is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those securities, countries or sectors.

Issued in the UK by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorised and regulated by the Financial Conduct Authority, 12 Endeavour Square, London, E20 1JN and is a subsidiary of The Bank of New York Mellon Corporation.