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Because you asked… Thumbnail

Because you asked…

Answering more of your top investment questions

As we settle into a new year with the realization that it will take some time yet for the world to get a handle on the pandemic, it can be easy for investors to still feel quite nervous about the state of things, and if life will ever return to normal. But there are several strong indications that we’re heading in the right direction. When you factor in a global rollout of vaccines now underway, the transition to a new government in the U.S., a more coordinated coronavirus response south of the border, and a strong market recovery in Asia, there’s a lot of support for optimism in 2021.

With the understanding that investors still have questions, the Capital Markets Strategy team, led by Philip Petursson, Chief Investment Strategist for Manulife Investment Management, has compiled another set of top questions from advisors. Philip, along with Macan Nia and Kevin Headland, discuss the effects of growing government debt levels, portfolio balancing, emerging markets, and more.

These questions are based on a recent Investments Unplugged podcast — “Because you asked … round 2” — and is a continuation of a first round of frequently asked questions, available here.

Let’s get started …

From an economic perspective, what’s the impact of rising government debt levels due to coronavirus-related economic stimulus?

Government debt levels may be increasing in Canada and the U.S., but very little impact on market performance is anticipated. Down the road, fiscal stimulus may result in smaller decreases for Canadian and American currency rates and slight increases in interest rates, but no extreme or shocking movement in dollar decreases or interest rate hikes are expected.

More importantly, investors should consider the implications of not being invested in equities. Government debt levels tend to have very little impact on the companies that trade on the equity markets. If there’s concern, it’s important to examine asset allocation within a client’s portfolio and consider the risk. On the sovereign bond side, there’s more exposure to risk for investors, with lower risk on the credit and high-yield side. As a result, we’re looking at shifting exposure from sovereign to high-yield and corporate credit this year. Real estate, commodities, and stock in companies with the ability to stay strong in the face of rising inflation may offer good protection. In a worst-case scenario, the best thing is to own stocks and real assets that will thrive in a rising inflation environment. Real assets like gold, historically, provide protection against inflation while companies with pricing power in the market can adjust prices for inflation.

The absolute worst-case scenario, which has a very low probably of happening in North America, would be government defaults on debt, resulting in a dramatic rise in interest rates and a potential devaluation of the currency. Worst-case scenarios have played out where governments defaulted on debt in Zimbabwe, Venezuela, Russia, and Argentina.

Are central banks expected to implement negative interest rates in Canada or the U.S. in the near future?

After examining the effectiveness of the negative rate strategy in other parts of the world, such as Europe and Japan, the general view by the Capital Markets Strategy team is that it’s largely a failed experiment, having little to no impact on either economic growth or inflation. When you look at the banking sectors in those parts of the world that have implemented negative rates, the profitability of the banking sector feels the impact, putting it in a more vulnerable position.

Negative rates can also have a significant psychological deflationary effect. When rates are decreasing, consumers looking to borrow funds may exhibit more of a wait-and-see attitude, hoping that lending rates will continue to drop lower, whereas FOMO (fear of missing out) tends to prompt borrowers to act quickly when rates are rising.

With the concept of a K-shaped recovery, how important is a recovery in the services sector?

The letter K suggests that parts of the economy are experiencing a strong recovery while other parts are not. Every economic recovery is going to be uneven. During the 2008 market shock, the financial, housing, and manufacturing sectors felt the brunt of the downturn. This time around, the hospitality and travel sectors are bearing the weight of pandemic-related shutdowns.

While painful for those companies and employees involved, the current downturn in the services sector has a lighter impact on stock market performance overall, with market performance more heavily weighted to manufacturing. When you consider the S&P 500 Index, more than 50 per cent of the companies listed are strongly tied to manufacturing.

But this also points to the importance of active portfolio management and understanding the opportunities that exist or adjustments that are needed based on company performance targets and how that might affect stock prices. Stock prices related to airlines, cruise lines, and hotels may be depressed during these pandemic closures, while online streaming services and delivery companies rise to new heights.

The pandemic is also creating interesting new synergies and revenue streams within the traditional service sector space. Along with takeout food orders, many restaurants are now offering grocery essentials, cook-at-home meal kits, and free delivery on orders over a certain dollar value. Along with click-and-collect, more grocery chains now offer home delivery.

Consider this Solutions magazine article, “Make no mistake, the stock market isn’t the economy,” to understand why we shouldn’t confuse the terms stock market and the economy.

As we look ahead to the remainder of 2021, do we see a rotation from growth stocks to value stocks?

Whether a certain company or sector is considered a growth or value stock is open to interpretation. A better way to look at it is to examine how a company is setting itself up for success through its growth and valuation. Find good companies that are delivering consistent growth and watch out for over-valuation. If you overpay, you’ll under-earn.

Certain sectors, such as financial stocks, may have lagged in the 2020 market bounce-back, with factors including delays and deferrals on loan repayments having an impact on profitability. But through the pandemic, health and tech stocks have delivered strong performance, with the digital pivot and high demand for online video conferencing, along with the rapid response vaccine development, personal protective equipment manufacturing, and medical treatment innovation for those infected with COVID-19.

When we look to growth, what’s the outlook for emerging markets over the next 12 to 18 months?

Emerging markets have a lot going for them that make them an attractive investment opportunity — in particular, Asia, which is 70 per cent of the Emerging Markets Index. Governments in China, Taiwan, Korea, and Vietnam have managed the pandemic very well, to the point that they’re growing again. Not only have they recovered from the lockdowns of early 2020, but they’re ahead of where we are in North America and Europe — particularly China and Taiwan.

There are a lot of positives to consider when it comes to Asia as a source for economic growth. It’s home to 60 per cent of the global population, generates 20 per cent of global GDP, has a growing middle-class demanding products and services, a strong labour force, and an expanding population that rivals other parts of the world experiencing shrinking and aging demographics.

We need to become more comfortable with investing in that part of the world and let go of the fear that investing in Asia is risky. Yes, markets will ebb and flow, but overall, strong opportunities exist.

What is the future of the 60/40 portfolio?

Traditionally the 60/40 portfolio has delivered optimal risk-adjusted investment returns, with the 40 per cent dedicated to fixed-income balancing out the volatility of a 60 per cent equity weighting. And as retirement approaches, more of the portfolio is shifted to fixed income for even more stability. But as Canadians live longer, and more retirement funds are required, growth is important.

What needs to be re-evaluated is income needs in retirement — how much of a portfolio is dedicated to fixed-income during retirement and what’s in that fixed-income section. There are opportunities beyond traditional long-term government bonds that offer stability but fall short on generating any significant returns, such as corporate credit. High-yield and emerging market bonds present attractive growth opportunities within the fixed-income space as well. Given the current low interest rate environment, which is expected to continue into the next decade, a portfolio weighted to a higher ratio of fixed income could present challenges for generating expected returns.

The thinking around portfolios and retirement may need a new viewpoint. Do we automatically move to a higher weighting of fixed-income in retirement or leave the asset allocation heavier on equities (typical of pre-retirement settings)? For the best investment returns in retirement, we may see a shift away from the more traditional approach of higher fixed-income. But it’s not only the allocations. We may have to take a look at the type of fixed-income in our portfolio. High-yield debt and corporate credit may take up a larger portion of the 40 per cent fixed-income allocation. Then, if we look at the 60 per cent equity allocation in retirement, maybe it’s the type of equities in the portfolio that could make all the difference. Large cap, dividend-paying equities with strong fundamentals could be substituted for some of the high-growth riskier assets in the pre-retirement portfolio. The 60/40 allocations stay the same but the risk profile changes.

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