Vaccines keeping risk on table – for now

A year into the coronavirus crisis, there's broad consensus among asset owners that vaccination programs will give risk assets a further lease on life this year but less agreement about the pandemic's longer-term effects on portfolio construction.

The short-term picture appears bright.

Continued momentum on vaccines should help the global economy rebound strongly midyear as households in the U.S. and Europe emerge from lockdown, predicted Rupert Watson, London-based head of asset allocation with Mercer Investments. "Everybody I know wants to go and do stuff, whether it's go on holiday, go to a bar, catch up with friends, see relatives. And with the massive buildup in savings over the past year, "people have the cash to do it," Mr. Watson said.

That's not to say the horizon lacks clouds — such as a potential sustained uptick in inflationary pressures — but for now they remain distant.

"We're a little worried about valuations but the recovery and (monetary and fiscal) policy support will dominate this year and as a result ... we are overweight equities for our clients," said Mr. Watson, who oversees tactical allocation calls for Mercer's outsourced CIO clients in Europe. For example, if a client's strategic asset allocation calls for 50% in equities, "we're now in practice actually at 54% equities," he said.

Longer term, a number of market veterans predict considerable changes to come in positioning portfolios, with the pandemic and the policy response it elicited ushering in a new, more complicated environment for asset owners.

Whether it's the end of the "great moderation in bonds," the cresting of globalization or the embrace by governments of activist economic policies, institutional investors are living through a "turning point to a new paradigm," a multidecade change when it comes to portfolio construction, said Sue Brake, chief investment officer of the A$170.9 billion Future Fund, Melbourne.

Erik L. Knutzen, New York-based managing director and CIO of multiasset class with Neuberger Berman Group LLC, agreed, saying, "We're in a new economic cycle — (not) just an extension of the old economic cycle with a severe dip — and a new investment regime as well." That new regime will be "characterized in our view by headwinds to economic growth, headwinds to interest rates and a big question mark about inflation," he said.

Some observers noted that the pandemic has affected more than financial markets.

The bigger issue is that the coronavirus is raising questions about the "business models" of segments of the institutional universe, such as universities, foundations and health-care organizations, said Cynthia Steer, investment committee chairwoman of Washington-based ICMA-RC's $39.6 billion in retirement assets under management.

If, for example, four-year in-person enrollment stops being the norm for universities, how endowments invest and what they invest in will change, Ms. Steer noted, adding that "for most investment committees, this is a no-win right now and there is real stress here — and probably not well understood by the larger boards and finance committees."

After a period where asset owners were caught up responding to pandemic-related challenges, a wave of portfolio restructuring could be in the offing this year, some industry veterans said.

Pent-up demand for portfolio structure reviews could fuel "a large increase in manager search activity" over the coming year, predicted David J. Holmgren, CIO with Hartford Healthcare, Hartford, Conn. Asset owners had been putting off those reviews while "fighting the Fed" remained a no-win proposition, but in the wake of the Fed's extraordinary policy response to the pandemic last year more appear to be sensing that "the beta ride on large cap and lower rates is no longer the easy trade," he said.

After a decade or more where investors could consistently outperform high-profile endowments like Harvard and Yale by parking 60% of their portfolios in large-cap U.S. equities and 40% in U.S. Treasuries, market players predicted the post-pandemic environment will force investors to kick a more diverse set of tires — with a wider dispersion of results.

Decadeslong super cycles for stocks and bonds are giving way to a world with a far greater array of "drivers," calling for a more granular approach to investing, Ms. Brake said.

The Future Fund has added a number of new asset classes over the past seven or eight months, she noted while declining to offer details, explaining, "it's really hard in these markets because we're a big player and they're not always liquid."

Ms. Brake said the moment in time calls for doing more rather than less in tweaking portfolios. At a time of such dramatic change, "incrementalism is our enemy," she said, adding, "the worst thing we can do is keep cranking the handle on a model" that was perfected for a different environment.

"You've got to work harder to find exposures that are diversified for the kind of world that we now live in because bonds were one of the things that paid us to insure our portfolio and that's over," Ms. Brake said.

Neuberger's Mr. Knutzen said his team is working with clients as well to find higher levels of reliable income than sovereign bonds offer at present, looking at high-yield bonds, bank loans, emerging market debt, CLOs, catastrophe bonds, private credit and others. The goal is to allow clients to "capture as much of (their) return as possible from income and be less concerned about capital appreciation," he said.

Other asset owners, while conceding that U.S. equity valuations appear high and sovereign bonds no longer offer significant yields, said they remain hesitant to make significant asset allocation changes in response to assumptions about big asset classes topping or bottoming out.

"Philosophically, I don't believe in making those kinds of predictions," said Michael G. Trotsky, executive director and CIO of the $80 billion Massachusetts Pension Reserves Investment Management Board, Boston. "We make gradual changes. If you're making big changes in any given year, you're being tactical" and just as likely to prove unlucky as lucky, he said.

Still, acknowledging that the flood of fiscal and monetary stimulus being deployed around the world now has chipped away at bonds' diversifying benefits, Mr. Trotsky said PRIM's investment committee is on the lookout for other diversifying assets and could take "another hard look at hedge funds" this year.

Aware Super, a Melbourne-based superannuation fund overseeing roughly A$140 billion in retirement assets, likewise hasn't shifted allocations significantly over the past year, said David Goodman, economist on the fund's investment strategy team.

Despite heightened economic uncertainties now, some things remain the same. "We still ... believe that equities underpin our portfolio and drive returns ... and we still fundamentally believe that fixed income provides diversity to our portfolio," even if its effectiveness as a hedge isn't as great as it used to be, Mr. Goodman said.

He noted that a year ago, in the depths of the pandemic sell-off, even holders of negative-yielding German sovereign bonds enjoyed diversification benefits as yields became more negative.

As of Jan. 31, Aware Super's largest offering — its balanced growth default option — had a 37.1% combined allocation to Australian and overseas equities and a 15.6% allocation to sovereign bonds, with alternatives, credit and cash accounting for the remainder.

As of June 30, 2019, the most recent fiscal year close before the coronavirus emerged, that option's allocations to equities and sovereign bonds stood at 37% and 20%, respectively.

Meanwhile, Richard L. Tomlinson, CIO of the Local Pension Partnership, a London-based manager of £19.9 billion ($27.9 billion) in retirement assets, said his team made changes on the margin to its portfolio exposures last year but no big strategic or tactical asset allocation changes.

During the worst months of the pandemic crisis, Mr. Tomlinson said he added modest allocations to equity and credit, having learned a painful lesson in 2008 not to take risk off the table at a time when the threat of systemic risk for global markets effectively guarantees that economic policymakers will do whatever it takes to right the ship.

LPP's nominal return target of 4% to 5% — 4 percentage points or so above short-term rates — effectively expelled high-quality fixed income from its portfolio "a long time ago," leaving it with an endowment-like portfolio that carries a lot of equity risk, he said.

For the coming year to 18 months, most investors expect a market environment that will continue to favor equity allocations, in anticipation of progress in vaccination programs that will end lockdowns around the world and ignite a rebound in global consumption.

"COVID has led to an interesting combination of excess investment capital and supercharged fintech, health-tech and biotech innovation," noted Charles Van Vleet, assistant treasurer and CIO of Providence, R.I.-based Textron Inc.'s $7.6 billion defined benefit plan.

Though some of that excess capital may be finding its way into GameStop and bitcoin, it's also moving into some truly disruptive companies in segments that include genetic research, remote medical services and fintech, said Mr Van Vleet, adding that the next 18 months are "not a time to be underweight risk assets."

"You need to be fully invested in this environment because the weight of money (in play now) means that this thing is not going to suddenly stop," the Future Fund's Ms. Brake agreed.

At the same time, the Future Fund team believes the new environment will be more fragile — subject to sharp bouts of volatility.

"In an environment where markets are more fragile (different from volatile or uncertain), you want to have a war chest … to have the flexibility to be able to move the portfolio around as that fragility gives you opportunities," Ms. Brake said.

As of Dec. 31, the Future Fund reported having 19.8% of its portfolio, or A$33.8 billion, in cash, as a means of maintaining that flexibility, she said.

Mercer's Mr. Watson likewise noted that one of the things the pandemic has done is remind people that some things can't be forecast — with the resulting need to better diversify portfolios and be in a position to execute quickly if need be.

If a consensus view now calls for both economic growth as well as inflationary pressures to jump over the coming 12 to 18 months, the outlook over the medium term is far murkier — with many observers expecting a return to the low-growth environment of "secular stagnation."

For the short term, it's very clear that "we're going to get higher levels of inflation" amid a burst of activity as pent-up demand gets unleashed, said Aware's Mr. Goodman. But whether or not fiscal policy continues to be deployed sufficiently to maintain higher levels of growth following that spurt will be "THE question" for markets and for the global economy's recovery over the medium term, he added.

Neuberger's base case is "we don't get sustained reflation beyond a 12-to-18 month horizon but that's what's going to be the biggest driver of differentiation among investors over this coming two to three years," Mr. Knutzen said.