Special Halftime Report, Part 4
Part 4: Portfolio risks and the impending U.S. presidential election
For the past three weeks, we’ve been running this special series in an attempt to answer the seven key questions about what lies in store for investors after the pandemic fades. In Part 3, we tried to put current central bank stimulus into context and revisited our longer-term macro outlook to see if changes were warranted. In this final part of the series, we’ll get down to the nitty-gritty of where the portfolio risks lie, and of course, the biggest question of all: the impact of the U.S. presidential election in November.
Question 6: What are the key portfolio risks for the rest of the year?
Two key risks have increased during the Covid-19 pandemic. In fact, both are blinking bright red right now. First, concentration risk. Consider that U.S. assets were the stars of the bull market out of 2008 – a Michael Jordan-like era of uninterrupted stock market leadership. American stocks and bonds soared during this period. In the global currency market, through which more than $5 trillion normally swirl every day, traffic was one way: out of every currency in the world and into U.S. dollars.
Looking back, American domination does make sense. In environments of subdued global growth, U.S. stocks and the senior global currency tend to thrive. The makeup of the U.S. stock market, with its larger weighting in growth stocks, is also a factor. Growth can command a premium with a sluggish backdrop.
Yet U.S. assets have soared even more this year during the pandemic, building into a dangerous crescendo that leaves plenty of room for underperformance. The U.S. stock market is now priced for perfection. The dollar is about as overvalued against its G7 peers as it has been for 30 years. The five largest stocks in the S&P 500 now account for nearly a quarter of the index. And everyone is in on the trade.
Much of this is related to investors piling into the “stay-at-home” trade, which has chased many technology companies higher. But this is almost certainly a case of investors overestimating permanent changes during a crisis. Yes, we are all live on Zoom now. And, yes, many will work from home. But many more things will return to normal. And deep structural shifts cited earlier argue for changing trend lines, even faster growth in the coming years.
What’s more, investment leadership changes result from a crisis. This may be happening right now, with the U.S. stock market showing relative weakness over the last few weeks. In comparison with U.S. growth stocks, many equity markets are priced as if the pandemic will be with us for years. Expectations for many regions outside of the U.S. are abysmally low (with record flows in 2020 out of globally-oriented funds), valuations are far cheaper, and ex-U.S. growth stories are starting to attract capital. Combined with America’s waning leadership (diminishing its attractiveness as a destination for foreign capital), a major rotation is likely underway.
The second risk relates to income. As if low interest rates were not a problem in the pre-virus world, now they are public enemy number one for retirees and savers. What to do to combat low rates and financial repression? Ironically, equity markets have become a better source of income than bond markets. Yet the underlying risk of equity is clearly higher. Piling into equities to generate yield would lead to inappropriate risk levels for many income investors.
Another approach (which our investment team actively pursues in our income-oriented strategies) is to become more eclectic and global in one’s quest for reasonable income. This means scouring the world’s asset classes for decent yield. This can be found in emerging market bonds (who have not blown their public balance sheets like the West has and provide a juicy yield), U.S. high-yield bonds (which have the tailwind of the largest underwriting of corporate risk in history), real estate investment trusts (many of which trade on far lower multiples than Canadian or U.S. listings), and, yes, dividend-paying stocks from developed markets (Euroland is a particularly fertile hunting ground).
The biggest benefit here is that investors do not have to compromise the only free lunch in investing – diversification. With many yield-oriented asset classes still deeply on sale, it is now possible to generate a higher income in the post-virus world. Crucially, exposures to Western government bond markets should be minimized.
Question 7: What will be the impact of the U.S. presidential election?
Experience has taught us that it’s best to leave the room after making any political predictions. Toss the grenade and walk away. This is especially true of the reality TV show that has become American politics. The U.S. is now more polarized than any other major country.
Still, let’s indulge the topic. First, it is becoming clear that putative Democratic Party presidential candidate Joe Biden is steadily gaining in the polls (even if one’s heart sinks that this was the best candidate a nation of 330 million people could come up with). If Biden does win, fears of higher taxes, more regulation, and an avalanche of welfare programs would initiate a fall in U.S. stock prices. If the incumbent Republican Donald Trump wins, then the investment and social climate could get even more hostile. Ramping up trade wars, inflaming social divisions, and more erratic foreign policy would almost surely define the next four years.
Given that neither of these scenarios are clearly bullish to investors, the above uncertainties are now weighing on the U.S. stock market. Investors should be watching developments closely. And they should be bracing for the possibility that Kanye West will be president in 2024 – the most unlikely person to be voted in since, well, Donald Trump was (and, for the record, that would make Kim Kardashian the First Lady).
The first half of 2020 seems like a work of fiction. Surely the plot was made up, and we will all wake up from a bad dream? As it is, we continue to live in an era of new realities, jagged pills, and rough edges. The year 2020 will be an important demarcation line in our collective memories for some time. Where were you when the entire world went into a total lockdown?
But, in financial markets, policymakers show no signs of slowing down stimulus. The music is still playing. Prudent action in this environment is to build portfolios that can survive and withstand the shocks of a modern world – and to keep a sharp eye on the disc jockey. Our investment team will be doing just that for clients. In the meantime, let’s all breathe now (just not on each other).
Tyler Mordy, CFA, is President and CIO for Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. He specializes in global investment strategy and ETF trends. This article first appeared in Forstrong’s March 26 issue of “Ask Forstrong,” available on Forstrong’s Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at firstname.lastname@example.org. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.
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