These are unprecedented times. The challenge facing investors is how to construct portfolios in an environment where asset prices appear disconnected from the real economy and the resolution of the health crisis is murky.
Our analysis, discussed in greater depth in our Asset Allocation Outlook publication, suggests that valuations of risk assets (equity and credit) are approximately fair, after adjusting for easy financial conditions and assuming a gradual economic recovery. Nonetheless, the distribution of potential economic scenarios over the next 12 months is unusually wide.
As such, we believe investors should maintain a moderate risk-on posture in multi-asset portfolios with a focus on companies with strong secular or thematic growth drivers that are positioned to deliver robust earnings in a tepid macro environment. As always, robust portfolio diversification is critical, but achieving this requires a multi-faceted approach. Duration, real assets, and currencies all can play an important role.
One silver lining is that volatility and uncertainty often lead to great investment opportunities. We believe the next few quarters will present a great backdrop for active management as the nature and the pace of the recovery will create many winners and losers. That should provide a plethora of opportunities to add value through sector selection and tactical asset allocation. Portfolios that are thoughtfully constructed, well-diversified, and sufficiently nimble should be in the best position to navigate the months ahead.
Global equities: We are overweight U.S. equities given the higher share of high quality and growth companies. We are also overweight Japan, which has improving quality characteristics, attractive valuations, and cyclical exposure that is more tilted toward sectors we favor. We are underweight emerging markets and European equities, as these regions are more cyclical and therefore less resilient to a downside scenario.
From a sector perspective, we favor technology and healthcare where innovation is occurring. We believe disrupters in these industries have the potential to deliver high earnings growth in an otherwise low-growth world.
Traditional credit: We prefer high quality investment grade (IG) corporates that we think may provide attractive risk-adjusted returns across a range of recovery scenarios, while being cautious about exposure to highly levered entities. We also see opportunities in select senior financials and bank capital, as well as noncyclical BB rated high yield credits.
In other credit sectors, we are overweight agency mortgage-backed securities (MBS). Agency pass-through securities appear to be trading at attractive valuations and stand to benefit from ongoing policy support. They also provide an opportunity to go up in credit quality while offering similar yield and better liquidity. We also favor European peripherals given their current spreads and because we expect the policy support to continue.
Nontraditional credit: Dislocations in other parts of the credit markets have created attractive risk/reward opportunities.
We continue to find value in structured credit markets, particularly AAA rated senior securities backed by a diversified pool of assets; examples include commercial MBS, residential MBS, and collateralized loan obligations (CLOs). Legacy non-agency MBS remain attractive from a valuation perspective given supportive U.S. housing fundamentals.
In emerging markets (EM), we are emphasizing external debt over asset classes that tend to be highly growth-sensitive, such as EM equities, currencies, and local debt.
Private debt: Private markets take longer than public markets to show signs of stress. We are starting to see compelling opportunities in segments such as commercial MBS and private loans. We expect further repricing to occur in private debt markets over the next 12 months, reflecting weaker economic conditions and less competition from lenders. Additionally, companies previously able to access traditional sources of financing may be forced to turn to private capital sources.
We believe opportunistic strategies will play an increasingly important role in many portfolios in the coming years as investors seek to achieve their long-run return objectives.
Portfolio diversification: Similar to the procyclical portion of a multi-asset portfolio, the risk mitigation component calls for a nuanced approach in the current environment. Instead of relying on duration as the sole anchor to windward, we believe investors need to employ a much broader toolkit consisting of diversifying assets with explicit or implicit government support, risk-off currencies, and alternative assets and strategies.
While term premia are low across the board, we favor the U.S. and Australia given higher yield levels and therefore more room to fall in a flight-to-quality event. At the same time, we believe a well-diversified and targeted duration position should be complemented with other risk-mitigating assets.
The opportunity set can consist of risk-off currencies such as the Japanese yen and Swiss franc, high quality assets receiving policy support such as agency MBS and AA/AAA rated IG corporates, as well as diversifying alternative strategies. Investors can also consider allocations to gold, which tends to be a resilient asset and has delivered diversification in many past recessions and periods of high macro uncertainty.
For detailed insights into our views across asset classes, please read our July 2020 Asset Allocation Outlook, “Building Resiliency Amid Uncertainty.”
Erin Browne is a managing director and portfolio manager in the Newport Beach office, focused on multi-asset strategies. Geraldine Sundstrom is a managing director and portfolio manager in the London office, focused on asset allocation strategies.