Exploring alternatives to bond allocations in a post COVID-19 world
Global Investment Insights
with Garry Evans, Chief Strategist - Global Asset Allocation, BCA Research
Garry Evans heads the Global Asset Allocation service as the Chief Global Asset Allocation Strategist at BCA Research (BCA), the largest independent macro research house in the world. He is based in Montreal, Canada, and has been at the firm since 2015.
In his role, Garry’s primary focus is on advising clients through the portfolio construction process and making recommendations on how to position a multi-asset global portfolio.
The core client base Garry services includes pension/superannuation funds, family offices, wealth managers and other, what may be considered, conservative investors all around the world. The key areas of interest for these clients at the present time mainly centre around:
Outlook for inflation and whether the build-up of excessive debt levels that has occurred (particularly in the past 12 months) is going to end badly.
Structural aspects of portfolio construction, such as factor investing in equities, how to hedge FX exposure when buying foreign bonds and stocks, and in ESG.
In August 2020, Garry published a detailed report titled, The World After COVID-19: What Will Change, What Will Not? In the analysis, he assumed that we would have vaccines and that the world would therefore return to normal within 12 to 18 months. While we have not yet returned to normal, the world economy remains on track to recover by early 2022 as the vaccine rollout continues. Nevertheless, Garry’s conclusions remain relevant. Many of the changes to the way we work and live that we have experienced during the pandemic will prove to be sticky. “I don’t see people going back to work in offices five days a week again, and that means that where they prefer to live will also change. The consequences of this could be very negative for real estate, particularly city centre commercial real estate”, Garry highlighted.
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The future is very bright for the healthcare sector. We have simply underspent on healthcare in the past few decades.
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Despite this, Garry sees a very bright future for the healthcare sector. In his words, “we have simply underspent on healthcare in the past few decades, and digitalisation of patient records, for example, is still very backward.”
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We might be entering a new “commodities supercycle”.
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Another interesting area is alternative energy. “I think we have got to the point where it is on the verge of taking off. This should produce tremendous demand for commodities such as lithium, copper, nickel etc., which will be required to build out “smart power grids”, wind turbine farms, and other such innovations. This raises a question of whether we might be entering a new “commodities supercycle” of the sort that we last saw in the 2002-12 period”, Garry explained.
As far as challenges facing the institutional investor community are concerned, without a doubt, the low interest rate settings are key.
“When I first studied finance the rule of thumb was that the assumed return for a pension fund should be similar to the yield on BBB corporate bonds”, Garry remarked.
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If bond yields, and therefore likely bond returns, are so low, why should investors own government bonds at all?
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He continued, “currently that yield in the US is only about 2.1%. Yet, US public and private pension funds typically assume a return of 7-7.5%, which is totally unrealistic. Assumed returns in Australia are somewhat lower, but still rather optimistic compared to the likely range of outcomes.”
This begs the question, if bond yields, and therefore likely bond returns, are so low, why should investors own government bonds at all? And the answer is that “in many jurisdictions, investors are forced by their regulators to own government bonds”, Garry retorted.
“I have had many discussions with investors in recent months about whether a 60-40 equity/bond portfolio makes any sense anymore. So, if you do not want to hold bonds much further into the future, what do you buy? The answer is you probably need to look at alternative debt instruments such as leveraged loans or infrastructure investments. You might also want to look at high quality equities, for example the Dividend Aristocrats index, to replace a part of your bond portfolio”, Garry advised.
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If you do not want to hold bonds much further into the future, what do you buy? The answer is you probably need to look at alternative debt instruments or high-quality equities.
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Geographically, “BCA Research has long been negative on emerging markets (EM), but they are now starting to look attractively priced, on a relative value basis compared to US equities. We see a chance that the US dollar will continue to depreciate over the coming years, as a result of the particularly aggressive monetary and fiscal expansion in the US. EM is inversely correlated to the USD. If there is a new commodities supercycle, as I suggested earlier, that too would be positive for EM”, Garry explained.
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Emerging markets are now starting to look attractively valued.
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He continued, “the obvious other asset that investors will need to be in is equities. This is the TINA story – there is no alternative. My capital market assumptions work has led me to the conclusion that the long-run return from global equities going forward will only be about 3-4% a year in nominal terms, about half the historical return. But the return from bonds is very closely linked to the yield at the starting point. That suggests a balanced global bond portfolio is likely to return around 0% in nominal terms over the next decade. That means you have little alternative but to be, at least in the long run, overweight on risk assets such as equities.”
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A balanced global bond portfolio is likely to return around 0% in nominal terms over the next decade.
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Garry left us with some lessons learnt from his long career, with a key takeaway for him being, the importance of keeping things simple.
He elaborated, “when I first worked as a strategist, I was often inclined to say that in six months this or that will happen, and therefore I will change my recommendations later. The problem of course is that if I am smart enough to figure out that something will change, the market is going to work it out too. So, if you have an idea, it is always best to act on it now.
The same is true, for example, of sector selection. I have found that doing sophisticated analysis never pays off. If you think that we are in an expansion, go overweight cyclical sectors. Don’t try to overthink it and, for example, play value versus growth.
I think a temptation for those of us in the financial industry is to show off our expertise and demonstrate we can apply the sophisticated statistical techniques we studied. In reality, doing the simple things correctly and in a timely fashion is much more important.”
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Investors have little alternative but to be overweight risk assets such as equities, in the long run.
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Disclaimer
All information contained within this publication is general advice only, as the knowledge levels and needs of all individual and corporate investors vary greatly this publication should not be used solely as a decision-making tool, further opinions and information should be sought before making an investment decision. It is the recommendation of Global Investment Institute (GII) that you seek the opinions of a fee-for-service, independent investment adviser before making any investment decision.
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