Investors should focus on cyclical equities, which benefit from a strong economic recovery. At the same time, they should use options and own some gold and Treasuries to protect their portfolio, according to Andrew Harmstone, head of Global Balanced Risk Control Strategy at Morgan Stanley.
It’s a dilemma many investors are wrestling with: how can I still add yield to my portfolio in the current low-interest environment? And do government bonds still function as a safe haven in neutral investment portfolios? After all, during the height of the coronavirus crisis in mid-March, 30-year US government bonds were sold off, while the S&P 500 lost around 30% at the same time. In other words, the traditional buffer function of Treasuries did not work properly. So should investors discard the asset class altogether?
For Andrew Harmstone, that would be a step too far: ‘US government bonds recovered quickly after. Moreover, they actually performed as expected this year and provided better downward protection than other fixed income securities.’ But the outlook for 2021 is significantly less buoyant. Morgan Stanley expects synchronised global economic growth, thanks to decreasing uncertainties and the rollout of coronavirus vaccines.
‘We expect a reflationary environment and see 10-year interest rates in the US exceeding 1.1%. With upside risk if the economy recovers faster than expected,’ says Harmstone. ‘For 30-year Treasuries, the outlook is likely to be even worse. But despite our view that yields will rise next year, negative economic surprises can never be ruled out. In such a scenario, markets will go into reverse and yields will fall again. That is why government bonds still deserve a place in investment portfolios.’
Gold as an inflation hedge
Morgan Stanley expects US GDP to return to pre-crisis levels by the end of 2021 and inflation to temporarily exceed the Federal Reserve target. ‘On the other hand, there will be a smaller fiscal stimulus than this year.’ Moreover, the moderate rise in housing costs is limiting inflationary pressures, according to the asset manager. ‘Looking further ahead, a narrowing of output gaps and a shift in globalisation trends towards a more local focus are likely to support a return to higher inflation,’ Harmstone believes.
In his view, this makes gold an attractive investment, which could replace part of the allocation to long-duration bonds. ‘Although gold has already done well this year, we tend to hold on to gold as a diversification and as a geopolitical and inflationary hedge. If inflation picks up more than expected, gold is a much more effective hedge than long-duration bond.’
Chinese government bonds and other emerging market bonds are also considered attractive as they still offer positive real yields, unlike most developed bond markets. ‘Inflation in China is low and will increase only slightly in 2021,’ says Harmstone. ‘An increase in interest rates is therefore not to be expected and liquidity remains abundant. Although higher yields are achievable elsewhere in emerging countries, these bonds are also more risky. Chinese bonds therefore remain relatively attractive. Nevertheless, we do not see Chinese bonds as an alternative to Treasuries and Bunds, but as a diversification in a traditional bond portfolio.’
Vulnerable corporate bonds
Investment grade corporate bonds, too, are currently less suitable as an alternative to safe government bonds. ‘We find the investment grade segment expensive and see little room for a further decrease in risk spreads. In the high yield market, spreads can be further reduced,’ says Harmstone. In addition to gold, Morgan Stanley also uses options to protect portfolios against unexpected risks.