We have seen an uptick in volatility recently as a number of events have weighed on investor confidence. How have you been positioning the portfolios and what should be top of mind for investors over the coming months?
Stock volatility increased significantly in the fall, and over the last few days, as the rising number of coronavirus infections, U.S. election uncertainty and the lack of a Congressional stimulus bill weighed on investor confidence. In our view, the recent fluctuations in stock prices represent a consolidation within a broader upward trend. Moreover, the optimism that had built up through the summer has been dialed back, and investor sentiment is now more supportive.
Moreover, credit markets appeared well behaved throughout the most recent risk-off period and central banks are continuing to provide ample liquidity, suggesting a more meaningful decline in stocks is unlikely. Our view that equities will likely outperform bonds over the medium to longer-term remains unchanged given historically low bond yields and the fact that stocks are reasonably priced on a global basis
Over the last two months, we have added to our equity position, sourcing the funds from fixed income. Our bias would be to look for chances to boost risk exposures in our portfolios rather than dial them back.
Monetary policy looks set to remain accommodative, keeping rates lower for longer. How are you positioning your portfolios given the current outlook?
The fact that central banks continue to purchase bonds in large quantities and inflation pressures remain muted suggests that bond yields will likely remain low, and we forecast that yields will be mostly unchanged over the next year. The U.S. 10-year yield has fluctuated between 63 and 70 basis points in the past month and it remains well below our estimate of equilibrium. While valuation risk is quite elevated in sovereign fixed-income markets, we don’t see any near-term catalysts that would push yields meaningfully higher.
U.S. 10-year T-Bond yield
Source: RBC GAM, RBC CM as of September 30, 2020
Over the medium to longer-term, a gradual increase in sovereign-bond yields would generate low single-digit to slightly negative total returns, potentially for many years. This has important implications for investors who hold bonds in their portfolios – namely lower expected returns and reduced income. The realities of a low interest rate world means investors – particularly those who fit a more conservative profile – are going to need evaluate whether their portfolios are positioned to achieve their long-term investment objectives.
Some of the ways we have evolved the portfolios in light of the current environment include making adjustments to asset mix as well as adding new funds or capabilities as they become available. This summer we increased our strategic equity weight to bolster expected returns to offset those in fixed income. We are also blending in assets with relatively low correlation to traditional equities, or bond-proxies. An example of this would be the allocation to direct real estate with the addition of RBC Canadian Core Real Estate Fund across several portfolios last fall. Direct real estate is a useful diversifier to equities while also offering superior yields. Lastly, the loss of income from falling coupon rates can be partially offset through our allocation to higher yielding fixed-income strategies and other vehicles with payouts above those of sovereign bonds.
It is important not to lose sight of why investors hold bonds: income, diversification and liquidity. Bonds will continue to play an important role in portfolios, but investors who hold them will need to evolve the make-up of this asset class to account for changes in interest rates and expected returns.
The global economy and financial markets are contending with a second wave of COVID-19. What are the implications from a portfolio perspective?
While the initial stages of the pandemic were met with massive fiscal and monetary policy responses and mandated shutdowns, action to address the second wave is occurring with less urgency. Governments are being more selective in tightening restrictions, closing businesses in hot spots rather than forcing entire sectors to halt operations as they did earlier in the year. As a result, the economic damage from the second wave should not prove as severe as the first, and a recovery is still underway albeit at a slowing pace.
That said, it is something we are closely monitoring along with other volatility inducing events such as the U.S. election and ongoing Brexit negotiations. Volatility will remain a persistent factor as these scenarios unfold and markets absorb their effects. Given the varying impacts of COVID-19 on different economies and the potential for heightened volatility going forward, we believe that diversifying across multiple regions will continue to be important for investors.