At a glance

Global markets have recouped their losses after the coronavirus-induced slide and as economies reopen. However, investors are awakening to a world that is more indebted, less global, and more digital. Now is the time to “reset for recovery” – as investors will now need to focus on finding income, managing volatility, and differentiating winners from losers.

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The road to recovery

Economies around the world are gradually reopening from their self-imposed lockdowns in the wake of the coronavirus pandemic. To stimulate the recovery, central banks have reduced interest rates to, or below, zero, and embarked on unprecedented quantitative easing programs. In this environment, the challenge to find income is made even more pressing given we think central banks may be willing to allow for a period of moderately higher inflation (e.g. 2–5%) in order to manage debt burdens.

Over the past months, government bond yields have fallen sharply in response to lower interest rates and have not rebounded even as economies and stocks have recovered. We don't expect yields to change materially, posing a challenge for investors looking to earn income and manage portfolio volatility. In short, we believe cash and the safest bonds are likely to deliver negative real returns for the foreseeable future.

Portfolio actions

Portfolio actions to find income:

  • Limit cash holdings to what's necessary. To protect purchasing power amid higher inflation, investors will need to reassess how much cash and safe bonds they hold. Our Liquidity. Longevity. Legacy. (3L) approach* suggests investors should set aside two to five years' worth of net expenses in cash and high-quality bonds. This provides a "buffer" so that the remainder of the portfolio can be invested for growth over the medium and long term.
  • Find and diversify sources of income. Investors will need to seek income from dividends and higher-yielding credits. The need to accept more risks to earn income heightens the value of diversification and careful portfolio management, and investors may want to delegate this decision-making to a professional.

Example of a diversified credit asset allocation

Example of a diversified credit asset allocation
Source: ۶Ƶ

In mid-August the VIX index had fallen back to c.21, not far above its long-term average of c. 19. However, comparing the average VIX level from January (14), when the S&P 500 was trading at similar levels to mid-August, with the average of the past month (25) shows that implied volatility is still well above pre-crisis levels. Also the reduction in VIX has been concentrated at the front end, while the six-month forward VIX remains close to 30.

With volatility still elevated investors may see it as a challenge since traditional portfolio hedges have such low yields.

Portfolio actions to manage volatility:

  • Employ a disciplined rebalancing approach. A key long-term cost of elevated volatility is that it can trigger indecision and leave investors stuck in "safe" but low-yielding assets for extended periods. But volatility can also present opportunities. A disciplined approach to portfolio rebalancing can allow investors to benefit during periods of volatility by aiming to "buy low and sell high" in a systematic way. It's worth noting that rebalancing at the height of a crisis can be psychologically challenging, so delegating or automating decision making on rebalancing can be an effective way of maintaining discipline.
  • Plan market entry and stick to it. Periods of volatility can also be good opportunities for investors to build up long-term positions. However, it can be unnerving to invest during volatile times because investors fear "regret" if they buy and the market subsequently falls. Investors could base their decision-making on levels of quantitative signals or indicators.

Investors will need to manage elevated volatility

VIX index

VIX index
Source: Bloomberg, ۶Ƶ, as of 19 June 2020

Even with higher volatility, equity markets overall are now close to prior highs, although the crisis has driven significant divergence between markets and sectors. We expect the trend of relative winners and losers to continue as the recovery evolves. We see further upside for stocks in both our central and upside scenarios for COVID-19.

Portfolio actions to differentiate winners from losers:

  • Make your portfolio more sustainable. Stocks and bonds exposed to the sustainable investing trend have outperformed year-to-date, and we think they remain well positioned in a post-COVID world. By turning toward a sustainable portfolio, investors can improve the quality of their portfolios while also exposing themselves to enduring longer-term themes.
  • Substitute some of your passive investments for thematic. Investors can make sure they're well positioned to benefit from the trends accelerated by COVID-19 by taking a more thematic approach within investment portfolios. By substituting a portion of their country-focused or global equity allocation for a thematic equity basket, they may improve the long-term performance potential of their portfolios. Investors may want to consider employing a "core-satellite" approach, combining a core, well diversified portfolio, with satellite investments in a variety of themes in order to combine careful risk management with exposure to growing trends.

Winners & losers year-to-date

Select thematic and sector performance year-to-date, in %

Source: Bloomberg, ۶Ƶ, as of 22 June 2020

Although financial markets have recovered their losses, we believe the post-COVID-19 world will not see a return to the "old ways" with markets having entered a new paradigm. Therefore, we believe that now is the time for investors to "reset for the recovery."

*Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise that wealth, or any financial results, can or will be achieved.

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Key investment takeaways:

  • Although markets have recovered their losses, we have entered a new paradigm.
  • It is time to reset for the recovery. The world after COVID-19 is one more indebted, less global, and more digital.
  • Investors will need to focus on finding income, managing volatility, and differentiating winners from losers.

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