2021 Outlook: Post-pandemic portfolio positioning

Key points:

• Prospects for industrial sectors, and financial markets, are being quickly redrawn, spurred on by pandemic-related trends
• Investment returns may be weaker in the medium term, than seen in the recent past, at a time of low rates and elevated equity valuations
• A focus on high-quality companies with strong growth prospects seems attractive in a period of low returns
• Technological change and sustainability are two areas that are benefiting from the effects of the pandemic
• A focus on portfolio diversification, perhaps including private markets, hedge funds and gold, may be called for.

This year’s unusual events, and the deep economic contraction caused by the pandemic, appear set to affect the outlook for major asset classes next year and many more thereafter.

While many effects of the pandemic are expected to be transitory and fully contained in the medium and long-term due to the event’s exogenous nature, some of the changes might be structural. With vaccinations likely to be rolled out across much of the world next year, the speed of the economic recovery seems to be a key question for investors.

Returns likely to be weaker

While next year should be calmer than this, uncertainties around structural changes may keep volatility more elevated than before the pandemic. That said, an analysis of prospects for leading economies and asset classes suggests that, with very low rates and high equity valuations, total returns for the core asset classes over the next five years will be relatively low.

Fixed income expectations

The expected returns for developed market bonds look poorer than seen in recent years largely due to the very low yield levels seen in many countries. Falling yields weigh much on returns for the asset class. For example, the nominal yields on 30-year government bonds in the eurozone and Switzerland are negative. That means that the anticipated returns for government and investment grade bonds are negative.

In the US and UK, our analysis suggests that performance will remain positive, however downward shifts of late seen in the yield curve have compressed them below 1%. European and US high yielding bonds appear to offer more attractive returns of about 2-4%. That said, adjusted for inflation, the returns for weaker quality bonds still hover a meagre 1% above zero. But if inflation climbs for a sustained period, realised returns on fixed income assets might be lower.

Equities to outperform bonds

Equities may find it tough to make substantial gains given their already elevated valuations on many measures. Furthermore, the elevated cyclically adjusted price-to-earnings ratio suggests contraction over the next five years. Despite that, dividends and net buybacks of shares are expected to provide a stable income yield. We believe that developed market equities could offer nominal returns of 5-7% annually over the next five years. Emerging markets may provide a risk premium of another 1-2%.

While anticipated returns may be historically low, equities still provide an appealing investment opportunity due to their growth component; a valuable commodity at a time when central banks seem unlikely to tighten monetary conditions next year and there does not look to be much scope for expansion. A focus on selecting high-quality companies exposed to secular growth trends, such as healthcare and technology, can help provide long-term growth in a more challenging, low-return, environment.

Technology and sustainability

Technological change and sustainability are two areas that are benefiting from the effects of the pandemics. Social distancing has led more activities, whether work or leisure related, to move online.

The trend to more digitalisation and virtual experiences has been accelerated in the last year. This is likely to change the outlook for real estate, transport, retail and leisure among other sectors. Events have put more emphasis on the fragility of our economic system, with its sustainability being more questioned.

Almost all the fiscal spending announced this year has a sustainable bias attached. Investing sustainably can offer long-term growth opportunities in the switch to a low-carbon era. And with the popularity for investing in such assets rising, the momentum behind sustainable investments is likely to strengthen.

Diversification, diversification, diversification

While uncertainty levels should decrease, compared to last year, they look set to remain relatively high as the effects of the pandemic roll on and geopolitical tensions persist. This suggests that portfolio construction and diversification will matter more.

With income return prospects weak and limited scope for capital appreciation, the effectiveness of a portfolio invested 60% in equities and 40% in bonds is slipping. This seems to point to managing assets in a more tailored fashion to address investing in a time of lower return and higher volatility.

Allocating to private markets, hedge funds or gold seems one way to aid performance prospects through a diversified portfolio. Private markets seem to offer plenty of investment opportunities at the moment. A high-volatility, low-return era may favour hedge funds, notably in fixed income, despite their relatively poor performance in recent years. Meanwhile, with real rates negative in many countries, gold may help shield portfolios from volatility without being a drag on returns.

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