Change may be the only constant over the coming months, but we now have a clearer sense of the collapse in global output caused by lockdowns and the initial speed of the recovery. This has led our economists to present a new central scenario for the world economy, involving continued but much slower growth over the next few months, followed by a renewed pick-up after vaccines become widespread this year. And yet the picture remains unsettling, with new cases of Covid-19 still in the hundreds of thousands worldwide, the advent of mini-lockdowns and the fact that despite heartening progress, at the time of writing, a vaccine is still not a done deal.
At the same time, the remarkable rebound in risk assets from their nadir in March 2020 means the remaining upside is likely to be limited, at least in the near term, even as policymakers pump out more and more stimulus. So on our journey into 2021, we will clearly need to traverse many more obstacles that require caution, making it something of an endurance test for investors. But some of the risks we face are, in fact, also catalysing opportunities.
How is the pandemic accelerating long-term investment themes?
For some years now we have discussed the long-term themes that are shaping the investment landscape – from technology, to energy, to demographics and politics. By fundamentally changing the way we live, work and play, Covid-19 has intensified the trends that lie beneath these themes.
Take technology. The switch to remote working, undertaken on a massive scale amid lockdowns, has sped up the theme of global digitisation – with tech companies the obvious beneficiaries.
Another example is the energy transition: the demand shock from the pandemic has heaped yet more pressure on oil and gas companies, whose business models were already challenged, at the same time as prompting a huge decline in global carbon emissions. Of course, we wish that drop had taken place under different circumstances.
In short: we have witnessed years of change in a matter of months.
Have bond yields reached their floor?
In some markets, maybe. 10-year German bund yields touched -0.85% in March 2020, but then it became clear the European Central Bank (ECB) sees limited value in further rate cuts, so that level will be tough to hit again. What’s more important than whether we’ve reached floors is that we’re definitely closer to them in many cases than at the end of 2019, for example, in the US and UK. And when we’re closer to the floor, the return potential is lower. So as at the end of August 2020, 10-year US Treasuries had delivered strong year-to-date returns of 11%, while equivalent German bunds had generated 3%. The context is that US Treasury yields started 2020 at a much higher level, so were able to fall further. Drawing all this together, we need to accept that the protection value of government bonds has fallen significantly, in our view.
If bond yields will struggle to fall much further, how do multi-asset portfolios now hedge their risky assets?
Within the asset allocation team, one option is to target rates markets which still offer more potential for yields to fall, such as long-end US Treasuries and maybe smaller markets like Australia (also at the long end) and South Korea.
We can also increase the use of currencies for risk mitigation, just as heads of governments (eg Donald Trump) and central banks (eg the European Central Bank) are more focused on foreign exchange when most rates are close to zero already and so they have fewer tools to stimulate the economy. We see sterling as a “risk on” currency, while the US dollar and the yen may be the best candidates for “risk off” behaviour in extreme market conditions.
Elsewhere, we can look for thematic risks and target them more directly – say, climate change – and new asset classes to increase diversification. In addition, we just accept the limited return potential (term premium) and risk mitigation from government bonds, so seek out other premiums with ideally limited mark-to-market risk.
Turning to corporate bonds, what level of credit rating downgrades have we seen and what do we expect going forward?
We obviously saw a huge volume of fallen angels in 2020, when downgrades during the heat of the crisis pushed a record amount of bonds out of investment grade. Although, to be fair, we expected a large number of these even before the onset of coronavirus.
It feels a lot calmer now – only a few months ago, it seemed as though every company we covered was on negative watch. That’s not the case anymore. A quarter of our investible universe currently has a negative outlook from one of the three major ratings agencies, which does suggest that there are more downgrades to come. But we think the pace will be much slower from here.
Are there any other reasons for credit investors to be cheerful – or at least, less anxious?
Well, it’s hard to overstate the importance of fiscal and monetary support. And while we do harbour a number of near- and longer-term concerns, I think investors can take heart from the fact that where we did see surprises in earnings season, they were mostly positive. Cash balances are also high, given the record bond issuance we’ve seen; this is not a liquidity crisis.
Because corporates have enough cash, this buys them time. So even the worst performing – those that remain in partial shutdown and offer no line of sight as to when revenues will recover – still have adequate liquidity to keep them going for some time.
In terms of portfolio construction, how do we view corporate bonds versus equities?
Importantly, these asset classes offer different risk premiums. Yes, they can behave similarly in extreme conditions (like March 2020) but in combination we believe they can generally help us to achieve positive returns in a greater range of outcomes.
Right now, investment-grade spreads have contracted a long way, with each region close to the median of the past 15 years, while 80-85% of the widening seen in 2020 already retraced. So going forward, we expect the return potential from credit to be more normal.
We believe equities offer a more symmetric return potential. Yes, US equities have generated a strong year-to-date performance, but returns have still been negative for the euro area and very negative for the UK. There are also sectors that still offer plenty of upside in positive vaccine outcomes, in our view.
Stepping back from pure investment returns, have Covid-19 and the other challenges facing the world changed the way we see our role as a responsible investor?
I think it’s fair to say that across the industry, there has been a greater emphasis on the “S” in ESG integration – whether in regard to healthcare, diversity or simply treating employees fairly in extremely difficult circumstances.
We’ve long focused on these areas. They are captured in our quantitative ESG scores and active ESG view, which also incorporates qualitative measures, and in the work carried out by our global research & engagement platform. This all helps determine how we engage with the companies in which we invest, and allocate capital on behalf of our clients.
What this period has done, though, is give us a renewed sense of mission – by reinforcing our message that investors can no longer justify inaction by saying, “this is all someone else’s problem – we are solely motivated by shareholder returns.” Through responsible investing, we must evaluate the externalities and wider context – by this I mean the impact of our actions on people and the environment.
Sonja Laud is chief investment officer at LGIM
Charity Finance wishes to thank LGIM for its support with this article