06 May 2020
In this environment, investors may need to consider a trade-off between lower, more reliable sources of income and higher, more variable forms, and whether they have the risk appetite for more illiquid assets.
Listen to Andrew McCaffery and Henk-Jan Rikkerink discussing these topics in the latest CIO update podcast.
Addressing the income conundrum
Equity and fixed income markets may have begun healing from their March panic, but they continue to face headwinds. Equity markets are currently looking through the shorter-term disruption to a potential recovery in 2021, following an unprecedented monetary and fiscal response.
But as parlous macro data continues to emerge over the coming weeks and months, we expect markets to reassess the scale of the economic damage. Much depends on how long it takes to end lockdowns, lift restrictions and restore confidence. For economies to emerge fully from this crisis, businesses need to believe they can operate without the threat of further infection waves and new lockdowns.
“Caution is extremely sensible, given the levels that markets have recovered to. And it is worth holding some cash and ensuring portfolios have defensive qualities at this stage,” says Andrew McCaffery, Global Chief Investment Officer.
Equity valuations are also likely to come under pressure as more companies reduce dividends and suspend share buybacks. While this may be a temporary phenomenon, it could take a number of years for share income to return to pre-crisis levels - especially where companies have received state support with conditions attached or corporate debt levels have increased dramatically.
Parts of the fixed income markets could also see income reduce. As countries borrow heavily to mitigate the impact of the crisis, fiscal deficits balloon and monetary policy remains loose, government bond yields are likely to be even lower and carry higher risk than in the past. This creates an income conundrum for investors that may have to be addressed in other ways.
Investors need to think about how to use government bonds
Growth investors too will need to think about how they use government bonds. Depending on their balance sheet size and rating, sovereigns may now offer less protection for investors wishing to offset overall portfolio risk.
This raises questions as to the effectiveness of a seemingly diversified equity/bond portfolio during a period in which correlations between asset classes may not be operating ‘normally’ due to the exogenous Covid shock. For example, if over the medium to longer term inflation re-emerges, defensive and growth assets may not have the same correlation as they have historically.
“For income and growth needs, finding a diversifier is a tough one,” says McCaffery, “It’s now harder to build the clear offset we had from government bonds, especially with the US Treasury announcing $3 trillion of funding and if yield curve control moves to the US and western world.”
In such circumstances, longer-term investors who can deal with illiquidity may wish to consider strategic alternatives that offer diversification and capital return benefits, where they have access to these. In the short term, areas such as real estate and infrastructure face challenges around income, tenant viability and counterparty risk. Longer-term, however, high quality real assets should provide both income and elements of diversification away from public markets.
For investors looking to retain liquidity, moving up the capital structure into investment grade credit remains a good option. There may also be select opportunities among high yield names as the size and nature of the central bank support evolves to support parts of this market.
Tactical opportunities emerge but discipline is required
While long-term strategic asset allocation depends on investor objectives, time horizons, appetite for risk and preferred asset classes, careful rebalancing is key during these volatile times. Long-term investors may also consider shorter-term tactical moves that aim to protect capital and add value at the margin.
“The journey is as important as the destination when it comes to the investment experience,” says Henk-Jan Rikkerink, Global Head of Solutions and Multi Asset, “These types of markets create indiscriminate selling, which creates opportunities. But taking advantage of those requires a disciplined approach. You don’t want to be too reactive and get whipsawed, and you need to consider that trading costs remain high.”
On a short-term view, commodity markets may provide some diversification benefits. Gold has regained its sheen as a store of value after a wobble in March, while oil markets appear to be off their lows. Oil prices continue to reflect little or no demand, but supply is disappearing rapidly. Eventually, these markets will begin to rebalance, potentially creating short to medium-term opportunities.
Winners and losers as supply chains shift
Opportunities are also emerging in certain industries that could benefit from the Covid crisis. Beneath the wider trend of moving from offline to online, the acceleration in digitisation within companies should boost software providers.
And, perhaps counter-intuitively, there could be opportunities in autos. While recent demand has fallen off a cliff, semiconductor players in the electric vehicle market should continue to grow strongly over the longer term. Car dealers with the best value chains are benefiting from social distancing measures that make cars more appealing than public transport. Finally, those companies that are more visibly contributing to society and taking better care of their employees should also outperform.
Among the losers will inevitably be more labour-intensive companies with less capacity for social distancing, as well as airlines, leisure and parts of the retail sector. While some companies are obvious winners or losers, others exist in greyer areas where in-depth analysis is required to understand the multi-year slope of recovery for each firm, their liquidity and solvency characteristics, their income profiles and how easy it might be to restart or modify supply chains.
“We are likely to see many supply chains go through some version of de-globalisation, or maybe some redesign of parts of supply chains. And we will try to identify the winners and losers from that,” says Rikkerink.
It is likely that the ‘just-in-time’ supply chain model will change significantly, as the efficiency of lower inventories is sacrificed in favour of greater contingency. Companies with strong operating leverage that can quickly ramp up supply as activity picks up will also have an advantage over those that experience delays.
Finally, from a regional perspective, we are seeing remarkable resilience in China. Some factories are back to near-normal 2019 levels, though services continue to struggle. By looking closely at how the recovery is playing out in China and Asia more broadly, we can begin to understand how it might happen in the West and where the opportunities may lie for both returns and, in due course, improved levels of income.
This document is for Investment Professionals only and should not be relied on by private investors.
This document is provided for information purposes only and is intended only for the person or entity to which it is sent. It must not be reproduced or circulated to any other party without prior permission of Fidelity.
This document does not constitute a distribution, an offer or solicitation to engage the investment management services of Fidelity, or an offer to buy or sell or the solicitation of any offer to buy or sell any securities in any jurisdiction or country where such distribution or offer is not authorised or would be contrary to local laws or regulations. Fidelity makes no representations that the contents are appropriate for use in all locations or that the transactions or services discussed are available or appropriate for sale or use in all jurisdictions or countries or by all investors or counterparties.
This communication is not directed at, and must not be acted on by persons inside the United States and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required. Fidelity is not authorised to manage or distribute investment funds or products in, or to provide investment management or advisory services to persons resident in, mainland China. All persons and entities accessing the information do so on their own initiative and are responsible for compliance with applicable local laws and regulations and should consult their professional advisers.
Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The research and analysis used in this documentation is gathered by Fidelity for its use as an investment manager and may have already been acted upon for its own purposes. This material was created by Fidelity International.
Past performance is not a reliable indicator of future results.
This document may contain materials from third-parties which are supplied by companies that are not affiliated with any Fidelity entity (Third-Party Content). Fidelity has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content.
Fidelity International refers to the group of companies which form the global investment management organization that provides products and services in designated jurisdictions outside of North America Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. Fidelity only offers information on products and services and does not provide investment advice based on individual circumstances.
Issued in Europe: Issued by FIL Investments International (FCA registered number 122170) a firm authorised and regulated by the Financial Conduct Authority, FIL (Luxembourg) S.A., authorised and supervised by the CSSF (Commission de Surveillance du Secteur Financier) and FIL Investment Switzerland AG. For German wholesale clients issued by FIL Investment Services GmbH, Kastanienhöhe 1, 61476 Kronberg im Taunus. For German Institutional clients issued by FIL (Luxembourg) S.A., 2a, rue Albert Borschette BP 2174 L-1021 Luxembourg.
In Hong Kong, this document is issued by FIL Investment Management (Hong Kong) Limited and it has not been reviewed by the Securities and Future Commission. FIL Investment Management (Singapore) Limited (Co. Reg. No: 199006300E) is the legal representative of Fidelity International in Singapore. FIL Asset Management (Korea) Limited is the legal representative of Fidelity International in Korea. In Taiwan, Independently operated by FIL Securities (Taiwan ) Limited, 11F, 68 Zhongxiao East Road., Section 5, Xinyi Dist., Taipei City, Taiwan 11065, R.O.C Customer Service Number: 0800-00-9911#2 .
Issued in Australia by Fidelity Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”). This material has not been prepared specifically for Australian investors and may contain information which is not prepared in accordance with Australian law.
ED20 - 151