Portfolio Allocation When Safe Havens Get Stormy

by Charles Roth, Thornburg Investment Management

What should investors do when textbook solutions aren’t working? The traditional 60/40 equity-to-fixed income portfolio allocation isn’t holding up so well amid this year’s market volatility. Of course, five months give or take shouldn’t mean much for long-term investors. But market dynamics that call into question rules of thumb should prompt them to reassess which rules still apply.

As Jason Brady, Thornburg’s president, CEO, points out in an interview on Bloomberg Markets, conventional wisdom around portfolio allocation can be problematic when asset classes don’t react to changes in economic and market conditions as expected. That may largely explain how the typical global 60/40 mixed allocation portfolio is down around 0.5% nearly five months into 2018.

Rising interest rates are coinciding with spikes in energy and materials prices and are starting to weigh on global growth, Brady points out. That doesn’t imply recession. But growth may already be plateauing as the jumps in commodities prices feed through to broader inflation and wage pressures. They, in turn, are fueling the monetary tightening in the U.S., reduced accommodation in Europe, and a suspected “stealth tapering” in Japan over the last few months. Reduced monetary liquidity is generating volatility within the very asset classes that typically should buffer against it.

“When we see volatility, especially to the downside, traditionally high-quality bonds help you,” Brady says. “Now we’re seeing that volatility come from changes in fixed income rates, and what was the safety net is now the cause of the volatility.” The Bloomberg Barclays U.S. Aggregate Index has shed around 2.7% since the beginning of 2018, while its Global Aggregate Index is off 2%. And it’s not just bonds, but also the usually defensive stocks: the MSCI ACWI Consumer Staples Index has lost 8.1% in the period, while the MSCI ACWI Utilities Index declined 1.4%. “These sectors aren’t (currently) as defensive as people think,” Brady notes. “So you have to change your way of thinking around what’s causing the volatility.”

Another change would involve how investors might benefit from it. Financials, for example, should gain from higher rates, which boost their net interest margins, even amid plateauing though still good global growth, relative to the lackluster levels so far this decade. Judging from the 0.16% return in the MSCI ACWI Financials Index over the last five months, many investors appear spooked after two strong years of gains in calendar 2016 and 2017.

Perhaps investors fear a flattening U.S. yield curve is signaling recession—a fear we don't share—and are looking back to the 2008 financial crisis, thinking they should shun financials. While some financials may face challenges, banks nowadays are better capitalized than they were a decade ago, and, again, benefit from higher rates. But just as generals tend to fight the last war, investors may be prone to doing the same: if they felt burned by banks in 2008, they would do well to recall that the S&P 500 Financials Index skyrocketed 50% from March 2000 to the end of that year, providing a big cushion when the tech bubble burst that same year.

In addition to thinking harder about the cause and effects of current market volatility and guarding against recency bias, current challenges to portfolio allocation also come from within asset class benchmarks. Over time, sector weightings in indices change for both cyclical and structural reasons, and do so across geographies. That implies past patterns may not continue in the future.

A decade ago, technology represented almost 17% of the S&P 500 Index, while energy and materials together comprised 18%. Today, technology is 26% of the index, while energy and materials are about half their 2008 weighting. Such changes are even more extreme, as we recently noted, in the MSCI Emerging Markets Index, in which technology’s weighting has nearly tripled to more than 27% today from 10% a decade ago, while energy and materials have gone from 32% to just shy of 15% over the same period. A big part of that story involves the ascendance of world-class technology companies from China, South Korea, and Taiwan, amid the decline in national champion resource companies from Russia to Brazil and elsewhere.

Interestingly, the MSCI EAFE Index, which is dominated by European and Japanese companies, doesn’t sport much of a technology weighting at just 6.5%, which is slightly more than its 5.2% weighting in 2008. Its energy and materials companies, however, shed meaningful weight, falling to 13.7% of the index today, from 20.6% a decade ago.

Structural tailwinds are clearly lifting the technology sector, from cloud computing and big data, to machine learning and artificial intelligence, not to mention robotics. Commodities, on the other hand, have long been subject to boom and bust cycles, but they, too, are facing structural shifts. Particularly the energy sector is confronting structural headwinds. Electric vehicles are expected to achieve upfront cost-parity with internal combustion engines by the mid-2020s,1 while the share of renewables in global electricity generation is forecast to jump more than a third from current levels by 2022, according to the International Energy Agency.

Are the variable outlooks in the tech and energy sectors reflected in their respective weightings in benchmark equity indices? Certainly, to some degree. Investors might keep that in mind when considering standard recommendations to rebalance out of one sector or geography into another. Lately, we’ve seen charts depicting the alternating outperformance of the S&P 500 Index (SPX) and the MSCI EAFE Index (MXEA) over the last four decades, with recommendations for investors to shift into international equities.


S&P 500 / EAFE Ready to Roll? 12/31/1969 - 5/23/2018

Source: Bloomberg

A case can easily be made to transfer money out of the U.S. to international and emerging markets equities based on relative valuations and earnings outlooks amid the differing stages in each region’s earnings cycles. But who’s to say that the S&P 500 Index’s outperformance of the EAFE is set to roll over? It’s been underway since November 2007, or for 10.5 years. Yet the longest observation of this alternating outperformance over the last 40 years was the S&P 500 Index’s 11.5-year run over the EAFE from February 1989 to August 2000. In other words, there could be room to run.

Rather than generic rebalancing out of sectors or regions, investors would be better served maintaining meaningful, long-term allocations to core asset classes. That includes factor exposures such as value and growth, not to mention market capitalization sizes. Why? Because these, too, can change over time. Despite the conventional wisdom, it’s been quite a while since value stocks have outperformed growth stocks. And while U.S. small caps in the Russell 2000 Index have beat their bigger S&P 500 Index cousins in the 10- and 20-year timeframes, they lag over the one-, three-, five- and, tellingly, 30-year periods.

It’s also worth noting that most large-cap constituents in the S&P 500, EAFE and EM indices are multinationals. So they may be domiciled in a particular region, but potentially source much or most of their revenue outside their home market.

Flexible, bottom-up, index-agnostic portfolio managers can pick individual stocks based on their assessments of intrinsic value, which includes a company’s balance sheet strength, cash flow prospects and quality of management, among many other factors. They may see relative value in firms classified as growth stocks by investment research firms or overpriced propositions in those classified as value stocks, and in both cases along the capitalization spectrum. The same is true of flexible, fundamentals-focused bond pickers who aim to provide income and total return with a strong mix of relative value propositions within the credit universe. Fixed income will continue to provide ballast to portfolios, despite recent travails.

Sensible portfolio allocation continues to require meaningful, long-term exposures to core asset classes, and perhaps to a lesser degree tactical allocations between them. As Thornburg CIO Brian McMahon says, rather than trying to time the market, money is better made over time in the market.


1. Bloomberg New Energy Finance

Copyright © Thornburg Investment Management

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