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Asset allocation in pandemic times

Every year in late fall, our senior investment management and research experts gather for an offsite to draft our Secular Outlook. This time around was unique, not only because the meeting took place virtually due to Covid-19 but also because of the disruption to economic and financial markets caused by the pandemic. Hence, when discussing likely developments for the world economy, identifying shifts in investment trends, and assessing market paths, we faced an unusually wide range of possible outcomes.

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Forecasting the return of asset classes is already difficult under stable economic conditions, because they display a much larger variance than the underlying economy. The pandemic and its unpredictable developments, coupled with sudden measures taken by governments to tame its propagation, make for an exceptionally volatile environment. While the announcements of vaccine approvals by health authorities brought positive knee-jerk reactions from markets, a relapse into confinement following the discovery of highly contagious mutations brought commensurately despondent reactions.

Covid as a maker of uncertainty
Among the many questions discussed by our experts, the impact of a vaccine and the shape of the economic recovery figured prominently. In terms of the response from institutions, we have seen unprecedented support from central banks and massive budgetary support from governments, which has led to sizeable deficits and even larger national debts. Today, consumers are understandably more conservative; they have reduced consumption, and we are witnessing significant precautionary savings, which has led to a savings glut – even in a world of ultra-low or negative interest rates!

The volatility index on the US equity index S&P 500 (VIX) is hovering around 25% nowadays, above its long-term average of 20%, and much above the unusually low pre-Covid level of 15%. Bonds, on the other hand, which are massively supported by central banks, are trading at lower volatility levels – around 40 for the MOVE index, which measures the volatility of US Treasuries and whose long-term average is above 80.

Covid as an accelerator of secular trends
While Zoom, Teams, and Webex were known by just a few only months ago, they now seem as common as coffee machines (what a pity that it is not as easy to engage in small talk over them). In the span of just a few months, the digital shift has accelerated by several years, which has resulted in the winner-take-all performance of tera-cap technology stocks able to capitalise on their oligopolistic infrastructure and services. Real estate, by contrast, is likely to suffer, but the jury is still out on how much the demand for retail and office space will be reduced after the pandemic.

Interest rates are likely to stay low for even longer, which will plunge many economies into Japanification.

Central banks were already stimulating before the pandemic, and some of them already had their interest rates at sub-freezing levels. Others, whose policy rates were still above zero, quickly pulverised them after the outbreak, in particular the US Federal Reserve. Government support, on the other hand, was virtually nowhere to be found before the pandemic, while it has become prevalent today in order to avoid an even costlier demise of entire economic sectors.

All these and other secular trends that have accelerated over the last few months will bring about major changes to financial markets. Interest rates are likely to stay low for even longer, which will plunge many economies into Japanification (weak economic growth and low inflation despite ultra-accommodative financial conditions provided by central banks). Finally, ‘money for nothing’ will keep zombie companies alive for longer, resulting in higher bankruptcy risks and more severe losses.

Reflecting the new paradigm: adapting our Strategic Asset Allocation
During the annual offsite, our experts focus on the big picture, mainly the outlook for long-term trends and bifurcations. Whenever they determine that the identified secular trends will likely materialise during the upcoming year, changes to our Strategic Asset Allocation (SAA) are proposed. This was very much the case in 2020.

It is important to note that changes are usually the finalisation of a gradual process rather than the result of an ‘out of the blue’ decision.

It is important to note that changes are usually the finalisation of a gradual process rather than the result of an ‘out of the blue’ decision. Our ideas are often initiated in some specialised or agile strategies, and if successful, they migrate to our Tactical Asset Allocation. These ideas are only upgraded to SAA status after they have been adequately ‘seasoned’ (i.e. thoroughly tested and refined under many market conditions) by our many experienced portfolio managers.

Let us remember the critical role of an SAA. For discretionary investors, who choose to delegate their investment decisions, it is an anchor, a fixed point in a turbulent world that marks the long-run, neutral investment position of a given risk profile in a set base currency. It may sound obvious, but when a financial tempest hits, investors’ assets belong in an SAA – not in cash! We treat the SAA as a neutral corridor from which we can smartly deviate depending on the winds, tides, and currents of the markets.

For advisory investors, who choose to make the final investment decision on their own, short-term opportunities may play a larger role, but watching the evolution of the state of the investing world is a core task. In this regard, monitoring changes to the SAA provides valuable direction on where to put emphasis in the next year – and what to avoid. That said, advisory investors should also use an SAA, at least implicitly, even if they are bound to make larger and more frequent deviations from it. Maybe even more so than discretionary investors, they should navigate back to it when the tempest strikes. To find out more about the choice between taking investment decisions on your own or transferring the responsibility to an investment professional, please read our article ’Discretionary vs advisory’.

How should you position your portfolio in the view of Julius Baer's experts?