There’s an important distinction between the views most strategists espouse and how money is actually managed. The budgeting of portfolio risk sheds more light on their market views than interviews or written content.
After inflation, the most common questions I receive are about the performance prospects of various asset classes. Since actions speak louder than words, the portfolios I manage should show you how I feel about relative opportunities and risks.
However, I appreciate the questions since most of the strategists I know don’t manage assets. I’m sure there are some who have portfolio management responsibilities but I just don’t know of many. It’s easy to have a view when capital isn’t at risk. To me, it’s far more valuable to see how portfolio risk is being budgeted.
Portfolio construction
Broadly speaking, there are three critical factors when deciding how to weight any asset in a portfolio:
- Expected return. Given that cash flows drive investment return, what are the long-term cash flow prospects or the investment base case?
- Expected distribution of return and volatility. What might the distribution of cash flows look like? How wide are the ranges of potential outcomes? How volatile might the returns be? What does the left tail look like? In other words, what could go terribly wrong? What is the asymmetry of return potential versus risk?
- Expected correlation. How differentiated are the sources of potential cash flows? How might the return streams interact with the other assets in the portfolio? Will this asset diversify or concentrate existing portfolio risk?
Since the future is uncertain, we can only make assumptions when answering these questions.
Our assumptions in early 2022 were that interest rates were too low and that risk was overpriced. As 2022 progressed, yield curves shifted up and risk sold off.
What now as much of the repricing is behind us?
Notwithstanding our view that monetary policy will continue to be tightened to dampen aggregate demand, and ultimately inflation, flattening and inverting yield curves are reflecting weak medium- and long-term economic growth prospects.
While long-term rates may rise as central bank balance sheets are unwound and increased supply pushes up the risk premium for owning sovereign bonds, we feel a lot of the repricing is already behind us, which makes high-quality, long-duration bonds attractive compared with other financial assets.
As a result, beginning several months ago, we started adding significantly to the AAA US Treasury, Agency and mortgage-backed security sleeves in the multisector income portfolios that I manage. The active weight of AAA securities is the highest it has been during my time managing the strategy.
At the same time, with nominal yields higher and spreads having nearly doubled from the tights reached a year ago, we closed our underweight to US investment-grade credit. While spreads could widen amid rising recession risks, in my opinion there is strategic or long-term value in these bonds given their low default risk. Relative to other risky assets, the potential return per unit of risk in US credit has become markedly more attractive as the ranges of outcomes have narrowed. The active position is a slight overweight, and I’ll look at adding more as our credit investors pinpoint opportunities.
Average spreads but greater risks
While credit spreads are wider than a year ago, and close to their historical average, we don’t believe we’re in a period that looks remotely average. A considerable percentage of the companies in the publicly traded high-yield universe have an interest coverage ratio below 1x. Thus the entire revenue stream of nearly one out of six high-yield issuers is needed to meet their bond obligations, leaving no breathing room for lower revenues or higher costs.
Over the past dozen years, easy access to capital has suppressed the number of defaults and bankruptcies in the broad economy — particularly within its most leveraged asset class: high yield. With economic growth slowing and corporate revenue poised to follow, not to mention higher labor and debt refinancing costs, investors aren’t being appropriately compensated in this universe. In my view, there isn’t enough expected return, considering what could go wrong. The range of potential outcomes remains too wide and is why I have maintained an underweight.
Are we there yet?
Market rallies are an event, while market bottoms are a process. A bottom requires a level of capitulation we’ve not yet seen.
When the S&P 500 Index bounced more than 12% from mid-June until the end of July, investors started asking whether the market had bottomed. While that’s impossible to answer without hindsight, here are a couple of historical observations:
- A market rally is an event, almost like a party. Once the momentum gets going, everyone wants to be there. Late arrivals don’t know what they’re celebrating, they just know that it’s the place to be and consequences are an afterthought.
- Market bottoms are more of a process than an event, and like hangovers, they take time to recover from and are often tinged with regret. A bottoming process weeds out the overleveraged and those who have stayed at the party too long. The aftermath of the bursting of the dot-com bubble from 2000 to 2002 and the fallout from the global financial crisis in 2008 and 2009 are good examples.
While holdings data suggest institutions (mutual funds, hedge funds, pension plans, etc.) materially de-risked their books in 2021 and have done the same in 2022, equities held by US households remain near all-time highs, according to the US Federal Reserve.
Historically, bottoming processes are cleansing mechanisms. During the cleansing process, everyone feels the pain, but I wonder whether we’ve felt enough yet.
Too imbalanced
Economic cycles tend to end when imbalances become too big and are then sharply corrected. In the late 1990s, the excesses were in technology hardware. We built too many personal computers and routers, laid too many fiber optic cables and so on, fueling the Internet boom. At the turn of the century, that overbuild was painfully corrected in the broad economy, in general, and in technology and Internet stocks, in particular. A few years later, a new bubble emerged in the form of too much credit being extended to US consumers, particularly mortgage borrowers, which of course led to gross excesses in residential real estate and banking, the correction of which spawned the global financial crisis.
Historically, there has been a consistent pattern of recurring economic and market imbalances. But sometimes they aren’t easily detected by the lay observer because they aren’t centered around a particular industry, such as technology or housing.
From the end of the GFC until the outbreak of the pandemic in early 2020, too much credit (both public and private) was supplied to nonbank corporations. However, that capital was not used to increase the production of goods or services, as evidenced by the anemic growth of the 2010s, the weakest decade of growth in 150 years. Rather than using capital to enhance organic revenue and profit growth, businesses financed higher dividend payouts, share repurchases and acquisitions to generate inorganic growth across all sectors, excluding financials. This explains why the 2010s produced outsized profits but saw a feeble economic expansion and a historic gap in wealth between the owners of capital and labor. The excess of this last business cycle was corporate leverage and profits.
In February 2020, credit availability evaporated. Companies were undercapitalized. An economic and market rebalancing began, only to be short-circuited by policymakers. As a result, more corporate debt was created and profits reaccelerated at the fastest pace on record.
Is a bottoming process underway?
Until the excesses of too much financial leverage, underinvestment in production and overheated profits described above are corrected, I’m skeptical about whether a durable recovery can take hold. I’m not an economist, but it doesn’t take one to know that pandemic-era stimulus didn’t replenish depleted capital stock or lead to investment in productive assets, which would have set the stage for sustainable economic growth. Instead of investing in plant and equipment or research and development, the government issued previously unimaginable quantities of debt so that consumers could buy more goods than the economy could produce. The result? Inflation running at 9%.
In my view, as growth continues to fade, so too will corporate revenues. Companies have fixed costs that need to be covered by revenues, and those costs are now structurally higher than before thanks to the rising cost of labor, interest on debt and environmental, social and governance (ESG) compliance, leading to what we think will be lower profit margins and an adjustment in asset prices to reflect this long overdue reality.
When will we know?
Historically, markets have tended to bottom when investors give up (stop caring, vow never to invest again and no longer ask, “Is this the bottom?”). I’ve lived through that twice and I don’t think we’re there yet. But when investors stop asking whether we are, we will be.
Robert M. Almeida is a Global Investment Strategist and Portfolio Manager at MFS Investment Management. This article is for general informational purposes only and should not be considered investment advice or a recommendation to invest in any security or to adopt any investment strategy. Comments, opinions and analysis are rendered as of the date given and may change without notice due to market conditions and other factors. This article is issued in Australia by MFS International Australia Pty Ltd (ABN 68 607 579 537, AFSL 485343), a sponsor of Firstlinks.
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