No one knows, but investors have options to cut through uncertainty.
by Claus te Wildt, Senior Vice President, Capital Markets Strategy, Fidelity Institutional
Key takeaways
- Nobody knows what will happen next in the economy. But if you have deep convictions about what could happen, that may influence your investment choices in the near term.
- Long-term investors don't need to, and probably shouldn't, bet on the next move in this unprecedented global economic situation.
- Instead, diversifying among investments that could do well in a couple of possible scenarios may make sense and could improve returns.
- My favorite pairs today are large-cap growth paired with small-cap value and the health care sector paired with financials.
The number one question debated at most Wall Street firms right now is: How long is the post-COVID economic boom going to last? The answer is key for a lot of investors: The way you see this playing out could influence some investment choices in the near term.
If you believe that the present post-COVID spike in economic activity is leading into a self-sustaining, multi-year stretch of above-average GDP growth, then you may also be in the camp of investors who believe that:
- The pickup in inflation is going to stick for a while.
- Interest rates are going to rise.
- You should invest in sectors of the equity market that have historically benefited from strong economic growth, such as value stocks, small caps, and sectors, such as industrials and financials.
If you believe that the current boom is going to fizzle out as soon as the fiscal stimulus fades into the past and that because of our aging demographics we're likely to see more modest growth rates, then you may also believe that:
- The spike in inflation is fleeting.
- Interest rates might rise but only slightly.
- You should invest in areas of the stock market that can deliver earnings growth without a lot of help from the economy such as large caps, value stocks, technology, and health care.
I have come to the very unsatisfactory conclusion that the answer to this question is "nobody knows." And the reason for this is that we are clearly in unprecedented territory. When did we ever have a global pandemic, with rapid, but globally different, vaccine rollout/acceptance rates, vast fiscal and monetary stimulus, and aging demographics at the same time? I can't recall any historical comparisons and without those, it is hard to figure this out. And by the way, this is common across the industry. Just look at the equity market's change in leadership during the second quarter (see growth vs. value).
The green line represents growth stocks (a proxy for transitory above-average growth) and the blue line shows the performance of value stocks (a proxy for durable growth). You can see that the style outperforming changed 3 times in the quarter! It seems equity market investors changed their minds multiple times based on the latest data release.
What should someone do now?
Let's start with what you don't want to do. You don't want to do what the equity market did in Q2: chasing the latest news and risk getting whipsawed multiple times. Following such an approach usually leads to buying high and selling low. (Believe me, I tried, it doesn't work.)
So what should you do?
I would probably start with the tried-and-true notion that when you don't know, or are very uncertain, you should never take on a lot of risks. You should make sure that you are well diversified. In this specific case, I think it means that you should broadly diversify your equity exposure with asset classes that provide exposure to both economic outcomes mentioned earlier.
These asset classes would be growth and value, large and small caps, and economically sensitive and non-sensitive sectors. Having many types of investments in your portfolio can smooth out returns over time and potentially reduce the magnitude of swings in value. But it's important to remember that diversification and asset allocation do not ensure a profit or guarantee against loss.
When I employ such a strategy, I like to think about investments in pairs that I view together as one investment. By combining them, you can expect a decent return, but with a much smoother ride. On the chart below, that would be the orange line, as it represents the performance of an equal investment in growth and value stocks at the beginning of the second quarter.
Think about that experience compared to an individual investment in either growth or value. On the positive side, you would have saved yourself a lot of stress by investing in both growth and value. However, some of you might also think that your return would have been a lot better investing in just growth stocks. That is true, but only with perfect hindsight.
I think a diversified approach is especially important in times like this, where we are in unprecedented territory and the outcome is very uncertain. Right now, my favorite pairs are large-cap growth paired with small-cap value and the health care sector paired with financials. Both pairs feature asset classes that are cheap compared to the rest of their peers and provide exposure to different economic outcomes. I think together they have the potential to beat the orange line in the chart above as well over the long-term—but at the very least should reduce volatility.
Of course, if you already have an investment plan designed to weather most economic environments, it can make sense to stick with your plan. If you want help to navigate the market now and in the future, consider working with a financial professional to build a plan that could work for you.
