The global economic recovery has gained traction in recent months. The quickening pace of vaccinations in the developed economies should inspire confidence that the momentum can be maintained. At this critical juncture investors are increasingly confident that COVID tail risks are fading into the rear view. That confidence doesn’t strike us as misplaced given that the short to intermediate term outlook appears more certain than at any point in the last 18 months. With the second half of this year shaping up to be the first period of truly synchronized global growth since early 2018, investors may look to update their allocations to reflect the changing opportunity set.
We recently spoke with Outsourced Chief Investment Officers (OCIOs) at Aon, Callan, and CAPTRUST for their take on how to best approach a maturing business cycle. We discussed some of the tactical shifts their firms had made in recent months as well as potential risks to the outlook.
How OCIOs are Positioning
The U.S. economy continues to perform. The expected growth in Q2 will show the domestic economy eclipsing pre-pandemic levels of activity by a noticeable margin. The Europeans appear to have righted the vaccination ship and are on track to progressively reopen their economies this summer and into the fall. While many emerging markets are still struggling with COVID outbreaks, sentiment has noticeably improved from earlier this year. Risk assets continue to perform, though at a moderated pace in recent weeks.
With the global economy regaining its footing, economic sensitive sectors have started to outperform. Underneath the surface the long-awaited growth to value rotation is materializing; ultimately the question for investors is whether that trend has legs. According to Grant Verhaeghe, Senior Director at CAPTRUST, it does. “In January of 2021 we shifted our growth tilt to value and more into small cap from large cap,” says Verhaeghe. “The change is really a function of business cycle positioning, we recognize that we’re shifting to a post COVID phase where GDP expectations, at least for 2021, are in the 7-9% range. That accelerated growth allows us to emphasize value in small cap specifically providing exposure to sectors that we think make sense in this environment, namely energy, industrials, and financials.”
That call proved correct, as cyclical sectors like energy have massively outperformed the S&P 500 year-to-date in 2021. With greater dispersion in performance amongst sectors, Aon’s Partner & Investment Solutions Director Mike Petrauskas brought up an important point: “Were managers sticking to their discipline? These things don’t last forever, the rapid moves over the last 14 months have focused us on ensuring our managers adhere to their mandate. Ultimately, we’ve benefited from that balanced approach.” Style drift is a perpetual issue but one that OCIO managers are well equipped to handle and is more likely to arise with significant shifts in market leadership.
Long-term interest rates have trended lower from a local high reached earlier in March. The outlook for rates has reached a critical juncture and we asked our contacts to opine. Mark Andersen, Senior Vice President at Callan, had the following to say: “Our forward-looking long-term expectations for the next ten-years featured a meaningful cut to our fixed income return expectations. That has had implications for OCIO clients and achievable outcomes.” Aon’s take: “We have added some duration back to portfolios relative to policy based on current rate levels. We’re still short because we think with stimulus and inflation there is more risk to the upside, but we have more duration exposure now than we did nine months ago.” CAPTRUST also mentioned they remained neutral on duration.
The forecast for rates inevitably involves taking a position on growth, inflation, and the evolution of the Fed’s reaction function. One of the risks that came up repeatedly in conversations was the potential for persistent inflation. Given the current ten-year yield of 1.50%, the market in general seems sanguine about such prospects. Bonds have bought the Fed’s narrative that this is solely base effect inflation through July. After that, inflation had better collapse or there will need to be a sharp adjustment in rates. Such an event would be akin to a “data tantrum” – whether that occurs is a central question that will be answered one way or another.
Verhaeghe at CAPTRUST commented that, “There is a legitimate concern globally about inflation. Certainly, I feel like with our clients and in the conversations we have I hear more inflationary concerns. However, the Fed is committed to the transitory view. We have a higher expectation for rates but don’t anticipate anything happening on the short end of the curve until there are material changes in the labor market.”
The next several months will be pivotal for the Fed. A few of the regional presidents have made public comments in recent weeks that it may be appropriate to consider the winding down of monetary stimulus. With inflationary pressures showing up in the data, it shouldn’t surprise investors if the Fed starts to prepare markets for a pullback from extremely accommodative policy.
Credit remains a challenging asset for OCIO managers. Spreads are extremely tight even with record issuance, at $270 billion; U.S. junk bond issuance through five months has surpassed 2020’s then record first-half issuance. “Nowhere to hide in credit” is how Petrauskas from Aon described the situation. Managers continue to search for yield on an attractive risk-adjusted basis and to that end CAPTRUST stated they preferred structured credit products with a retail tilt to corporate credit exposure.
Investors should soon have a much better idea as to whether the economy will revert back to the pre-pandemic trends of muted growth and inflation. In 2021, global economic growth will be robust, of that there is no doubt, but can a higher growth rate persist beyond this year? The outcome will have profound impacts on portfolios. In a low growth world, we can continue to expect that long duration, growth, and U.S. domiciled factors would outperform much as they have for the past decade. In the event the pandemic has inspired enough stimulus to shock the economy into higher gear we would expect that value, cyclical, and non-dollar denominated assets may finally have their day in the sun. There are compelling arguments on both sides; the next six months will be pivotal in clarifying which path we are on.
*Aon’s opinions are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Past performance is no guarantee of future results.