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European multi-asset: is there anywhere to hide?

2020 has already brought with it a new set of trials to test investors and we are not even halfway through the year. Given specific difficulties in Europe, it currently feels like there is nowhere to hide. But with challenges come opportunities, and we believe there are three things that European investors can do to reposition themselves for a changing world:

  1. Diversify your fixed income portfolio further; there’s more to fixed income than government bonds.
  2. Be selective between asset classes, but also within asset classes; change happens at different speeds and impacts regions and sectors differently.
  3. Think outside the box; the world is very different to what it was 10 years ago, and it will be very different in 10 years’ more. 

Diversify your fixed income

We were reminded in 2011 that bonds are not always a safe hiding place from equity risk. Across Europe, bond yields rose sharply as aftershocks from the Great Financial Crisis revealed weaknesses in Europe’s financial infrastructure.

Although equity markets suffered significant losses, that period became widely known as the ‘European debt crisis’. Indeed, as the possibility of outright sovereign defaults and a breakup of the euro became ever more likely, government bonds were perhaps even riskier than European stocks. Signs of a two-tier Europe – feared from early on in the European project – had emerged.   

2020 has brought us echoes of that crisis. The notion of a two-tier Europe has resurfaced; ‘peripheral’ bond yields have risen sharply again but, as in 2011, yields on German Bunds have fallen further into negative territory. At such low yields, however, Bunds hardly offer further solace at a time of continued uncertainty. In any case, one European sovereign default may be a problem for all of Europe.

Despite the high risks of investing in European government bonds, there is barely any compensation on offer for bearing that risk. But there’s more to fixed income than government bonds.

Corporate bonds sold off sharply in the recent crisis, and although the extent of future corporate defaults can’t be fully known, the yields on offer after the sell-off are substantially higher than those of government bonds (Figure 1).

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Switching between government bonds and corporate bonds doesn’t necessarily reduce or increase risk; it just moves it around. Government bonds come with interest rate risk and – at the moment – valuation risk, while corporate bonds come with interest rate risk and default risk.

Given the risk of sovereign defaults in Europe, government bonds are not the ‘risk-free’ assets that they were in the past, so yields just simply aren’t high enough to compensate investors.

Likewise, the yields on offer by corporate bonds appear more than enough to compensate investors for the risk of corporate defaults. Those investors that are able to invest across different types of bonds have more flexibility to choose the risks they think will be rewarded, and eliminate those that don’t. 

Be selective within asset classes

Crises normally bring about severe losses for households and companies, but this crisis has brought with it a devastating impact on the lives and health of people worldwide. Authorities globally prioritised – rightly – the health of their people over the functioning of their economies. The bulk of the economic effect, therefore, was self-imposed through public lockdowns and closures.

This crisis is quite specific in nature, but in one major way it is just like all other forms of change: it has affected different regions and sectors at different speeds and to differing degrees. As a result, risks to portfolios are also not created equally. Within equities, the consumer discretionary sector – containing companies that sell goods and services to consumers over and above their basic needs – has been hit hard, while healthcare, consumer staples and information technology companies have done well. Financials have been hit by rising defaults and mandated cuts to the dividends for which they were once prized. In other news, a separate crisis in energy markets has led to major losses by oil companies globally. Figure 2 shows the performance of these sectors in 2020 so far.

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With respect to regional allocations, we are all too aware of the wave-like nature of Covid-19 and how it went from a series of regional epidemics to a cross-regional pandemic. Although this is an extreme example, multi-speed change is to be expected; no two companies, sectors, countries or regions are the same, so they will inevitably be impacted differently by economic and market developments. As a result, investors should be active in changing their investment allocations in response to – or anticipation of – the dynamic set of risks and opportunities that arise. That means being active not just at the asset class level, but within asset classes, at the sector and regional levels too.

Think outside the box

We are at a crossroads in history that will accelerate change in the world. Looking back, there is only a handful of events or periods that stand out as formative in shaping the way we live today, and the current pandemic is likely to be one of them. But active investors are used to dealing with seismic shifts in the way the world works.

Ten years ago, we were recovering from the worst financial crisis in almost a century, the fuse on the US-China cold war was yet to be lit, and sustainable investing still sat on the fringes, where it had been for the prior 50 years.

Since then, we’ve been through (and come out the other side of) the longest equity bull market in history, hostility towards (and fear of) China has bipartisan support in the US, and the amount of assets invested in sustainable strategies has grown four-fold.

Figure 3 summarises some major thematic shifts over the last ten years that have necessitated a change in the way investors view the world.

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We certainly didn’t predict all of these shifts (and would be dubious of anyone who tells you they did), but they have not surprised us either. One thing investors can be sure of is that change will always happen. The global growth and inflation landscape – as well as the compacts between different members of society - will look entirely different over the next 10 years.

That has implications for portfolio construction as asset classes and the relationships between them behave differently, but it also has implications for the way that investors make decisions.

As Mark Carney – UN special envoy for climate action and finance - recently put it: the gulf between what markets value and what people value will close. We think it is already closing; markets are merely groups of people, and companies are nothing without their employees, their customers, and the environment they operate in. Figure 4 serves to illustrate the interlinkages between companies and their stakeholders; clearly, it’s not all about profits.

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This crisis has reminded us that some of the biggest risks don’t stem from economic or financial sources. Embracing a sustainable approach to investing can help you to understand such risks in the future and position your investments for a changing world.

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