Preparing Portfolios for Potential Volatility

Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

David Wong, chief investment officer, managing director and head, total investment solutions with CIBC Asset Management. 

In a soft-landing scenario where we avoid recession while inflation returns to central banks’ target levels, I think logic would suggest that equities are likely to move higher. 

That said, it’s hard to exactly know what’s fully priced in the market today, given that the U.S. market remains strong here late in March 2024. So, we’re up about 13% so far, year-to-date, close to the end of March in the U.S. markets. And importantly, there are signs that market breadth is expanding a bit beyond the Magnificent Seven stocks that we saw do so well last year. 

Last year, the U.S. market was up around 23%, but it was really in the information technology, communication services and consumer discretionary stocks that lifted the overall U.S. market. And those are the three sectors that the Magnificent Seven happened to reside in.  

But so far in 2024, we’ve had energy and financials join the party as sectors that are now beating the S&P 500, while discretionary stocks have actually moved to underperformance. So, a bit of a leadership shift so far. 

So arguably we’re starting to see breadth expand in the market, which is in part due to growing expectations for a soft landing.  

Now, this could continue if we see the economy continue to show strength, and inflation continues to fade. At the same time, I think we need to be at least somewhat concerned about complacency in the market and acknowledge that it’s the unexpected events that really move the markets. And if it seems that more and more investors are getting comfortable with soft landing, with the soft-landing idea, while the conclusion is far from certain, that could introduce some risk into the market. It’s therefore a very good thing right now that the bond market is reasonably attractive, and we believe that it can provide a hedge to investors should that soft landing turn out to be a little bit more firm than might be expected right now. 

The good news is that the opportunity cost of holding bonds over stocks right now is not too severe. Now, in a soft landing, bond yields are probably going to remain high, but not necessarily dramatically higher. They won’t necessarily need to move dramatically higher. So, with the Canadian bond index yield today at around 4.3% at the end of February, the longer-term return potential for bond investors is more attractive than it’s been over the last 15 years. 

In our view, equities today aren’t necessarily cheap. Multiples are slightly higher than historical averages in many cases, but they’ve also been undeniably working very well. So, they’re not excessively expensive either. So, it’s very hard to argue for any major underweighting to equities today. So, we’re quite neutral overall from a tactical perspective on the equity market. And rather than underweighting risk assets to express any concerns about upcoming volatility, we would recommend that investors look at ways to get more diversification away from some of the concentration that we’ve seen building up in the markets. 

For example, the U.S. market has grown to be a very large exposure in the global equity indexes. It’s around 70% of the developed equity index today versus about 50% just a little over 10 years ago. This could very well continue given there’s been a great deal of innovation in U.S. large-cap companies. But if you have the opportunity to match or even exceed the expected returns of that market with a different strategy in the realm of, say, alternative investments, then it’s not a bad idea to spread out some of the portfolio risk budget to these areas. So, we believe that certain types of private equity strategies such as those with managers that focus on profitable companies that can be improved with operational know-how and don’t rely on simple multiple expansion for their case for compelling returns, we believe that offers good forward-looking purpose into a diversified portfolio. 

Long-term asset allocation is unique to each individual’s circumstances, which include factors like the time frame for investment, the starting point of wealth, the ongoing income needs of an individual, the tolerance for risk and other factors. So, the tools that are available to investors to actually build portfolios are traditional bonds, traditional equities, hedge funds that have low or no beta to traditional markets and private assets such as private equity, private credit, private real estate and private infrastructure. 

Now, for investors with a long time frame, the ability to absorb risk and short-term volatility is obviously much greater. Over a 20-year time frame, for example, the U.S. and Canadian equity markets have not had a negative rate of return, but over one year, it happens about 25% of the time. 

So, a framework for investing that removes emotions from the equation needs to be just as much a part of the investing exercise as knowing what tools are available. So, our recommendation for long-term strategic asset allocation is to write down your own investment policy statement, or better yet, find an advisor who can help you with that exercise and provide you with guidance on what each asset class is designed to do in your portfolio from a forward-looking return, risk and diversification potential perspective. And then set target ranges for how much exposure is needed to get to your own unique end goals. 

With traditional 60/40 portfolios, we believe that the yields on the broad Canadian bond index today, which are at 15-year highs, represents a very strong argument for a 60/40 approach that includes global equities and diversified bond exposure. If we look at a simple 60/40 portfolio with 60% to global equities and 40% to Canadian bonds, over the past 20 years, to the end of 2023, investors would’ve compounded at a 6.8% rate of return. So, for investors who dutifully save $10,000 a year over a 20-year time frame, that’s $200,000 in contributions with much of that not enjoying much compounding at all, especially towards the later contributions. But nonetheless, that contribution still would’ve turned into $459,000 over that 20-year period. 

So, the gravitational forces for a long-term investor are yield for your bonds and earnings growth for equities. A couple of years ago, it might’ve been a more fair discussion to look at how low bond yields were at the time, and question the return prospects for 60/40, but that certainly isn’t the case today. 

Now, volatility is always present across markets, especially in the short term, and that creates a threat to disciplined investing for individual investors, especially those that don’t have a governance structure or a defined process for investment decisions. So therefore, a 60/40 portfolio increases the odds that investors can stay disciplined because not only is volatility reduced versus a 100% stock portfolio and returns are increased versus a 100% bond portfolio, but investors actually get more return per unit of risk simply by combining the assets. That’s the power of diversification. Over the last 20 years, the return per unit of risk for a 60/40 portfolio is 0.88 units of return per unit of standard deviation versus 0.73 for global equities. 

The 60/40 mix can further be refined with alternative investments as well. Now, these are actually very exciting times for individual investors with the number and quality of alternative products for qualified individual investors that we now see that allow them to access private markets. So, the new offerings that are coming out are far more investor-friendly than the institutional client offerings historically have been. There are no capital calls, the minimum investments are in the thousands, not in the millions, and there’s instant diversification available to private markets. And ongoing access to investing in these products is available rather than the short windows of opportunity that historically were available to invest in them. 

Right now, I think the market is looking at a couple of risks this year that are unique. The U.S. election year certainly will create some noise, but we don’t believe that the impacts will be too significant on markets. Geopolitically, there are two wars going on right now, and the toll on humanity is unfortunately devastating, but from a portfolio perspective, impacts have been quite limited. 

More secularly, if we think about the markets pre-Covid and the economy pre-Covid, we knew that total factor productivity, which are the gains in the economy beyond growth in land, labour and capital, was low for several decades, and the economic picture wasn’t that great. Now, this has been obscured by the massive liquidity created by central banks in response to the pandemic. And this is definitely something to keep an eye on, is total factor productivity is the only sustainable source of growth over the long term, and we aren’t likely to return to the easy monetary conditions that we saw since 2008 anytime soon. 

So, the outlook for the markets through 2024 continue to be quite data-dependent. Central banks are walking on a tight rope between sparking inflation again and seeing the lagged effects of tight monetary policy having negative consequences on the economy. Now, the conditions are there for a return to volatility at some point. Since 1980, intra-year drawdowns in the U.S. market have averaged about 14%. So far this year, we’ve only had about a 2% drawdown this year. So, prepare for the emotional battle when that turns, knowing that the compounding of returns takes place over time and not all at once. 

So, it’s always a good idea to save yourself from the self-destructive behaviour by proactively getting familiar with volatility as a two-way street and recognize that emotions can run high. So, we need to check ourselves with the base probabilities. Markets are historically up 75% of the calendar years, so that’s a pretty good starting point for any outlook before letting our imaginations get too carried away. 

Now, 2024 began with expectations for seven rate cuts, which fuelled some market optimism. Now, these expectations have declined throughout January, February and March, and the market’s chosen instead to focus on the special cases of growth such as artificial intelligence. And they remain, markets remain dynamic, and the causes of strong performance can shift quite quickly, and they are starting to broaden out as we’ve seen. So, it’s yet another stark reminder about the dangers of binary investment approaches. We therefore continue to have a meaningful strategic weight to diversify U.S. equities given the long-term evidence of innovation and earnings growth. 

In the near term, uncertainty remains around the surprising resilience in the U.S. economy under the current restrictive policy. The Federal Reserve’s Open Market Committee’s sharp focus on inflation argues for continued multi-asset diversification in portfolios. History shows us that market sentiment can change quickly, and the attractive bond yields available today could prove very useful in a flight to safety.