The month of September was a relatively bumpy one for investors. We decided to check in with Sarah Riopelle, Vice President & Senior Portfolio Manager to get her view on recent market movements and how she is positioning portfolios for the road ahead.
We have seen an uptick in volatility over the past couple of weeks in both stock and bond markets. What’s your take on this and what does it mean for investors?
We have enjoyed a strong upward movement in equity markets since the pandemic lows and have been cautioning that investors should expect increased volatility. I think there are a few things causing investors to be a little more nervous in recent weeks:
- The virus continues to challenge economies, most predominantly in developing nations where vaccines have been less available and more difficult to administer.
- The pandemic has disrupted global supply chains and hampered the flow of goods, causing worldwide shortages and/or price increases that could extend beyond the short term.
- Companies have started issuing negative guidance, causing slight downward revisions in earnings expectations.
- We have also had negative headlines around Evergrande, one of China’s largest real estate companies, and its ability to meet its debt obligations. Recent news suggests that the Chinese government appears to be intent on a swift resolution to this issue.
While these events have been unsettling for investors, it is important to remember that markets can go up and down. As a result, we should always expect some volatility in the near term.
Despite all the headlines and volatility in recent weeks, our GDP forecasts remain quite good historically speaking and the profit outlook remains robust. While we do look for growth in 2022 to be below the rate of 2021, our base case scenario is that the economy continues to grow at an above-average, yet slowing, rate.
Weighted average consensus real GDP
Growth estimates for major developed nations
Note: as of September 28, 2021. Source: Consensus Economics
Against this backdrop of good growth and moderate inflation, we remain overweight stocks. In addition, we are also holding a cash reserve as protection against volatility and to take advantage of opportunities should they present themselves.
A big question on the mind of investors – particularly more conservative ones – is how rising interest rates may affect the bond side of their portfolios. What are your thoughts on this and how should investors be positioning their portfolios?
Government-bond yields continue to hover near their lowest levels in 150 years, and we don’t believe that these ultra-low yield levels are sustainable. A rising yield environment has important implications for investors who hold bonds in their portfolios – particularly those that are more conservatively positioned.
From current levels, even a slight increase in yields would result in negative returns for sovereign bonds. So what are we doing about it?
- We are tactically underweight bonds in the portfolios.
- A year ago, we also changed the strategic asset mix to shift more to equities and away from bonds. We lowered our bonds weights both strategically and tactically across our portfolios.
- The pressure on yields will be most prominent in sovereign bonds, so we are moving our exposures out the credit spectrum and incorporating more investment grade corporates and high yield bonds. These types of bonds should produce better returns even in a rising interest rate environment.
- We are adding alternatives to traditional sovereign bonds such as real estate and absolute return bonds. We are also looking at other ideas such as mortgages and infrastructure.
The bottom line is that in this environment, investors, particularly more conservative ones, will need to evaluate whether their portfolios are positioned to achieve their long-term objectives.
It is also important not to lose sight of why investors hold bonds, namely to provide income, diversification and liquidity within portfolios - especially in the face of equity market volatility.
Another big question from investors is how much of their portfolios they should allocate to equities. With many equity markets reaching all-time highs recently, what’s your view and how are you positioning portfolios?
The S&P 500 has more than doubled from its March 2020 low and many global indexes have also climbed to new records. Our expectation is that the economy will grow at a good pace next year, which should lead to continued earnings gains and provide support for equity markets.
However, stocks do appear fully valued at these levels and continued earnings gains are becoming increasingly critical as valuations are rather demanding. While elevated valuations on their own are seldom the cause of bear markets, they do make stocks more vulnerable to shocks and can lead to periods of greater volatility like we saw in September.
Global stock-market composite
Equity-market indexes relative to equilibrium
Note: As of August 31, 2021. GDP-weighted average of RBC GAM fair value models for a variety of countries. Fair value estimates are for illustrative purposes only. Corrections are always a possibility and valuations will not limit the risk of damage from systemic shocks. It is not possible to invest directly in an unmanaged index. Source: RBC GAM
We have to recognize that given elevated valuations and the fact that earnings have recovered to their long-term trend, we are unlikely to see similar gains going forward and we have to lower our return expectations. Our base case scenario forecasts returns in the mid-to-high single digits for equities over the year ahead, which is well below the experience of the past 18 months, but still superior to our expectations for fixed income.
Although a variety of risks exist, we have been reluctant to cut exposure to equities, as we believe the economic cycle is still in its early to middle stages and corporate profits have room to run.