July 4, 2020
A quick summary of some dominant investing trends of the past decade: Low inflation, strong bond returns and the dominance of U.S. stocks. The 2020 midyear outlook from the global investment firm BlackRock suggests the coronavirus will drive changes in each of these areas and more in the months and years ahead. To find out more about how investors should adjust their portfolios as we work through the effects of the pandemic, I spoke this week with Kurt Reiman, BlackRock’s chief investment strategist for Canada. Here’s an edited transcript of our conversation.
Let’s start with the question everyone’s asking – how serious is the risk of a second market plunge in the latter part of the year?
Recoveries never go in a straight line. If there is another incidence that shows the coronavirus is not under control, this is something that could challenge stocks. In the United States, an election cycle is coming up in four months, and there’s some concern about legislators’ ability to craft any further fiscal relief measures to assist people who may be out of work for longer. I think these issues present risks to stocks. Especially in the case of the U.S., where they are coming off a long-running series of years of outperformance. That’s something that we would be thinking about over the second half of this year.
Many readers have asked about whether inflation will rise above levels we’ve seen in recent years as a result of government spending. Do you see inflation becoming more of an issue, or is deflation the bigger problem?
In the next month, deflation will be more of an issue. When you have oil prices that are down 36 per cent from the start of the year, rising rates of unemployment and, in general, an economy where supply is a bit in excess of demand, it tends to push down prices. But I think that some of the trends holding inflation low are going to be challenged in a post-COVID world. My sense is that we’re likely to see higher inflation over say a three- or five-year window than we’ve experienced in the past.
One of the themes of BlackRock’s 2020 midyear outlook is resilience, allowing one to achieve diversification and address risk. Practically speaking, what types of assets should investors consider adding to their portfolios?
If we think about today, I would be getting resilience in a portfolio from longer-maturity government bonds [maturing in 10 years or more] that tend to do well when the economy is in trouble. Within the stock market, there are factors that tend to perform better during slow or contractionary economic activity – factors like quality, which has done well this year. We define quality as companies that have higher return on equity, strong cash flows and resilient balance sheets.
How do you assess opportunities in the Canadian stock market compared with the U.S. market?
If I were to categorize the Canadian investor’s stock portfolio in broad brushstrokes, it would be one where Canada was de-emphasized over the past five to 10 years in favour of the U.S. I think that’s starting to run its course. It’s not that I don’t have concerns about energy and high household indebtedness in Canada. But relative price-earnings ratios between the two countries are a factor that speaks in favour of Canadian stocks, and then you add on to that the fact the U.S. has an election in four months where the policy choices are quite wide.
Getting back to the resilience theme, where do dividend stocks fit in? I’m asking in the context of them being something of a disappointment in the first half of the year.
The economic shutdown really hurt those higher paying, deep value, cyclical dividend stocks both in price return and, in some cases, the income, which was reduced or suspended. What I tend to think about for that idea of resilience is not so much the dividend yield, but rather companies that are raising their dividends over time.
Tech has been a star sector in the first half, even in the Canadian market. Can it continue?
Canada’s tech sector is up about 60 per cent in the past year and is now 10 per cent of the TSX. I think that’s just a really remarkable development. I am still constructive on technology – earnings expectations for Canadian tech are still fairly robust. Technology is really holding up – it speaks to the shifting behaviour and consumption patterns toward e-commerce, entertainment at home, remote work and distance learning, to name a few.
Your midyear outlook has a fairly hot take on bonds – they will offer less downside protection for portfolios because low yields make them less attractive. How should investors position the fixed income side of their portfolio for the next year?
We talked earlier about having some longer-maturity bonds in the portfolio. A way we have added risk to portfolios in a way we feel is prudent has been to raise our exposure to corporate bonds. Central banks are buying them and the income is more secure compared to dividends. We would be raising allocations not just to investment grade corporate bonds, but to high yield bonds, where there’s an even bigger income advantage. We are still wary of the energy sector within high yield because of low oil prices.
What about inflation-linked bonds, also known as real return bonds?
If we wanted to extend the horizon out further than a year and think about the next five or 10 years, inflation-linked bonds start to become a lot more interesting. We think that, for now, the world is characterized by low inflation. But we think inflation risk is likely to rise, and that’s where inflation-linked bonds tend to look interesting.
[Note: Real-return bonds offer payouts that adjust to the inflation rate.]
What’s your estimate of annualized stock market returns over the next 10 years for stocks?
They’re low relative to history. For large-capitalization U.S. equities, we have 6.1 per cent over the next 10 years; European large-cap equities are 7.3 per cent and Canadian large-cap equities are right in the middle at 6.4 per cent (all in Canadian dollars).
[Note these are all total returns – share price changes combined with dividends – without fees or inflation factored in.]
What about fixed income?
Government bond returns this year have been very strong. But now that yields are low and nearing a lower bound, that limits the return potential. Income is lower and total return potential is likewise. In Canada, the government bond [total] return over 10 years is 0.4 per cent.
There’s talk these days the 60-40 portfolio is dead and it’s based on the fact that bond yields are so low. Thoughts?
Few would realize that the 60-40 portfolio over the past 20 years outperformed the S&P 500. The 60-40 portfolio did better because it lost less in the drawdowns, even if it did underperform in the upturns. But I think the 40 per cent in bonds has to change. It doesn’t mean the 40 per cent has to come down, but what’s in there has to change [see above]. When I think of the 60 per cent in stocks, what comes to mind is exposures that tend to minimize volatility or somehow reduce the risk. Minimum-volatility stocks, quality stocks, sustainability [in terms of environmental, social and governance measures]. I would be thinking about how to tamp down the volatility of stocks, given that in [the] next 10 years we may not have the same ballast from government bonds that we’ve been so used to in the post-financial crisis period.
Let’s close with your take on whether the portfolios that produced great returns in the past decade work for the years ahead.
The portfolio that investors had over the last 10 years will not work the same way in the next 10. It’s natural at a time like this to think about the near term and to get consumed with the daily news flow. That’s important, but we’ve been stressing the strategic changes that investors need to think about now. Rethinking the role of government bonds in the portfolio, thinking about the potential for an increase in inflation, and the ways to protect an equity portfolio in non-traditional ways. This is the kind of work that I would be doing in a portfolio, rather than necessarily trying to time the direction of the markets or trying to predict whether there will be another potential setback in the next six months.
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