Following the extraordinary declines seen earlier in the year as economies across the world went into lockdown, equity markets have staged a remarkable recovery, leading to something of a ‘decoupling’ between financial markets and the real economy. At the end of June, the technology-dominated Nasdaq index was firmly in positive territory year to date, while the S&P 500 had seen a bounce of around 30% from its March lows.1
However, while markets have rallied, many businesses have seen their earnings fall dramatically, as lockdown restrictions have led to a massive collapse in private sector- generated cash flows. Valuations have expanded, with the S&P 500’s forward price/earnings ratio, calculated using earnings estimates for the next 12 months, reaching almost 22 at the end of June,1 the highest level since the dot-com stock-market bubble of the early 2000s.
Although markets appear to be pricing in a quick economic recovery as restrictions on economic and social activity are lifted, the very nature of the current recession, which was initiated by a state-imposed collapse in activity, makes the outlook particularly uncertain. Risk assets have been buoyed by the unprecedented policy response to the pandemic, with the US Federal Reserve cutting rates to zero and launching an open-ended asset-purchasing program. But, as we have learnt over the post-financial crisis period, monetary easing has a much greater impact on financial-market prices than it does on the non-financial economy. Should the recovery in the real economy be slow, or undercut by a resurgence of the virus, nominal cash flows and earnings will not recover, which could leave valuations for risk assets exposed.
Threats to Equity-Bond Correlation?
With equity markets arguably increasingly detached from fundamentals and likely to remain highly volatile over the coming months, pension plan investors may be looking to apply a disciplined approach to portfolio rebalancing and take some risk off the table. Since the late 1990s bonds have typically had a negative correlation to risk assets, but as 10-year Treasury yields moved sharply lower and have hovered between 60-70 basis points during recent weeks, return potential is likely to be limited over the near term. Furthermore, should increased fiscal spending by governments result in a more inflationary environment, the backdrop could be even more challenging for government bonds over the medium to longer term, making an allocation to this asset class less appealing. Pension plan investors may feel that it is more prudent to build up their exposure to a multi-asset strategy, which can allocate to assets that are underrepresented in their plan and which are uncorrelated to equities.
Should the recovery in the real economy be slow, or undercut by a resurgence of the virus, nominal cash flows and earnings will not recover, which could leave valuations for risk assets exposed.
One means of achieving these objectives could be through an actively managed, absolute-return investment approach, with a mandate to deliver returns significantly ahead of cash. Such a strategy can be designed to respond nimbly to capital-market opportunities, while seeking to deliver consistent returns and provide downside protection.
Fundamentals, With Flexibility
Newton offers a number of solutions to assist asset owners with rebalancing their portfolios away from equities. These include a variety of time-tested multi-asset strategies with absolute and relative-return benchmarks. We believe our Global Real Return strategy is particularly relevant given its global, unconstrained approach, and flexibility to allocate across different risk assets as the backdrop evolves and correlations change.
In addition to equities (which we can step away from to a significant degree if we see heightened risk of a major drawdown), the strategy has exposure to corporate credit and emerging-market sovereigns. ‘Alternative’ investments such as infrastructure, renewables and real-estate investment trusts can provide uncorrelated return streams. The strategy also has an insulating layer of ‘stabilizing’ assets, including government bonds, precious metals and derivatives, which is used to dampen volatility.
Pension plans seeking a ‘smoother’ funding outlook see the benefits of the strategy’s aim for low correlation to risk assets and low equity beta, and its objective to provide a consistent, asymmetric return.
We believe our Global Real Return strategy is particularly relevant given its global, unconstrained approach, and flexibility to allocate across different risk assets as the backdrop evolves and correlations change.
1 Source: FactSet, June 30, 2020
Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.
Newton Global Real Return Strategy – Key Investment Risks
- Performance Aim Risk: The performance aim is not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for returns to vary significantly.
- Currency Risk: This strategy invests in international markets which means it is exposed to changes in currency rates which could affect the value of the strategy.
- Derivatives Risk: Derivatives are highly sensitive to changes in the value of the asset from which their value is derived. A small movement in the value of the underlying asset can cause a large movement in the value of the derivative. This can increase the sizes of losses and gains, causing the value of your investment to fluctuate. When using derivatives, the strategy can lose significantly more than the amount it has invested in derivatives.
- Changes in Interest Rates & Inflation Risk: Investments in bonds/money market securities are affected by interest rates and inflation trends which may negatively affect the value of the strategy.
- Credit Ratings and Unrated Securities Risk: Bonds with a low credit rating or unrated bonds have a greater risk of default. These investments may negatively affect the value of the strategy.
- Credit Risk: The issuer of a security held by the strategy may not pay income or repay capital to the strategy when due.
- Emerging Markets Risk: Emerging Markets have additional risks due to less-developed market practices.
- Liquidity Risk: The strategy may not always find another party willing to purchase an asset that the strategy wants to sell which could impact the strategy’s ability to sell the asset or to sell the asset at its current value.
- Shanghai-Hong Kong Stock Connect and/or the Shenzhen-Hong Kong Stock Connect (‘Stock Connect’) risk: The strategy may invest in China A shares through Stock Connect pr These may be subject to regulatory changes and quota limitations. An operational constraint such as a suspension in trading could negatively affect the strategy’s ability to achieve its investment objective.
- CoCos Risk: Contingent Convertible Securities (CoCos) convert from debt to equity when the issuer’s capital drops below a pre- defined level. This may result in the security converting into equities at a discounted share price, the value of the security being written down, temporarily or permanently, and/or coupon payments ceasing or being deferr
- Counterparty Risk: The insolvency of any institutions providing services such as custody of assets or acting as a counterparty to derivatives or other contractual arrangements, may expose the strategy to financial loss.
- Investment in Infrastructure Companies Risk: The value of investments in Infrastructure Companies may be negatively impacted by changes in the regulatory, economic or political environment in which they operate.
This is a financial promotion. This document is for institutional investors only.
Issued by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorized and regulated by the Financial Conduct Authority, 12 Endeavour Square, London, E20 1JN and is a subsidiary of The Bank of New York Mellon Corporation. ‘Newton’ and/or ‘Newton Investment Management’ brand refers to Newton Investment Management Limited. Newton is registered with the SEC as an investment adviser under the Investment Advisers Act of 1940. Newton’s investment business is described in Form ADV, Part 1 and 2, which can be obtained from the SEC.gov website or obtained upon request.
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Material in this publication is for general information only. The opinions expressed in this document are those of Newton and should not be construed as investment advice or recommendations for any purchase or sale of any specific security or commodity. Any reference to a specific country or sector should not be construed as a recommendation to buy or sell this country or sector. Please note that strategy holdings and positioning are subject to change without notice.