At the Crossroads, Seeking Direction

by Erik L. Knutzen, CFA, CAIA, Chief Investment Officer—Multi-Asset Class,
Niall O’Sullivan, Chief Investment Officer, Multi Asset Strategies – EMEA, Neuberger Berman

Faced with historically inverted yield curves, unbalanced equity markets and economic conditions unseen for 40 years, investors are agonizing over their next steps.

Five months ago, we wrote that investing was “at a crossroads.”

Our view is that a new era of deglobalization, rising labor power, and changing monetary and fiscal policy, leading to structurally higher inflation and rates, and shorter and more volatile business cycles, demands a new investment playbook.

We’ve just returned home from several weeks on the road talking with clients. Between us, we covered North America, Europe, the Middle East and Asia, meeting the stewards of several trillion dollars of assets.

How are they feeling? Like they’re at a crossroads. Faced with a lot of options and uncertainty, they’re trying to identify the best direction in this new environment.

Lower Risk, Similar Return

Often first on the agenda was what to do when short-term bond yields are unrecognizable to anyone under 40 years of age. On a relative basis, they’re unrecognizable to anyone under 60; the U.S. Treasury curve inversion is deeper than at any time since 1981. The fed funds rate is close to the yield of the Bloomberg U.S. Aggregate Index of investment grade bonds. Clients in the Middle East are getting 6%-plus on cash deposits.

Many investors see an opportunity to reduce their risk while maintaining similar estimated returns, moving from equities to high yield, from high yield to investment grade, from full market investment grade to short duration, from short duration to cash-plus.

However, a lot of capital has had the same idea at the same time. It does feel that many “tourists” have been attracted into the simpler, easier-to-own assets, with yields and spreads having already compressing under the stampede.

As a result, a general theme we picked up on was a recognition that rewards remain for doing “harder” things. If you can stay alert to and access opportunities in more niche and less liquid parts of fixed income, higher yields and liquidity premia can be earned. Shorter-term money is less likely to chase yield here than in the more liquid markets.

Higher yields are causing fixed income allocations to increase. The shape of yield curves and slowdown concerns are leading many investors to short-duration assets. Rapid changes in spreads and prices are spurring many investors to use more opportunistic approaches. Finally, a growing focus on illiquid credit markets means investors are keen to improve the integration of their public and private allocations.

Making Equities Palatable

Second, what to do about equities?

We don’t recall a single investor with a positive view on broad market-capitalization-weighted equity over the next 12 months.

Our view is that inflation will be sticky, central banks will fight it aggressively, and therefore equity valuations may have further to fall while corporate earnings get hit by the lagging economic impact of tighter monetary conditions.

In return for those risks, the S&P 500 Index offers an earnings yield lower than the current pricing of the terminal fed funds rate.

So, clients’ bearishness didn’t surprise us—if anything, it reinforced our view that there is very little real-money support behind the rally we’ve seen since last October. And yet, very few investors can ditch equities completely.

Again, they are seeking direction. How can we make an equity allocation as palatable as possible in this environment? Discussions focused on ideas we’ve been outlining ourselves, notably in a recent paper: diversifying away from the winners of the past decade—U.S. mega-cap growth and speculative duration—and building more exposure to regional markets, smaller companies and the quality and value factors. Other conversations explored ways to add marginal return potential without adding downside volatility, or even by monetizing volatility with options strategies.

The Map Exists

Finally, we heard a lot of concern about whether decision-making processes need to be recalibrated. If we’re in an environment that we haven’t seen for 30 or 40 years, can we rely on models trained on the past 20 years’ data?

Interestingly, we often heard these concerns articulated in the context of private markets. Some of our most engaged conversations were about how to make models responsive to the changing environment by building in more subjective inputs, and how much easier that is when you can draw on a 35-year history of operating in private markets and all the rich data that implies.

These concerns go beyond the outlook for portfolio companies in the new environment—many investors appear to have mentally written down recent private equity vintages. Their focus now is on how to maximize opportunities in an era of costlier debt and less-liquid public markets, and an environment where many investors may be forced to stop allocating. Again, as with the public markets, many investors we spoke to saw potential reward for doing the harder things in private markets, and for deploying where capital is scarce.

It’s been great to be on the road, meeting with clients in person, often for the first time after several years of Zoom meetings. These conversations were always essential to the asset owner-asset manager relationship, but they are more critical than ever today. We were reminded that it’s unnerving here at the crossroads. The map forward exists—we are all in possession of separate parts of it, depending on our experience, specialisms and expertise. Continuing the conversation can help us build the full picture.

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