Monthly Markets Memo - October 27, 2020

World Money Small.jpgby Dan Zalipski, CFA 

Hope of a stimulus before the election is still up in the air.  The White House and House Democrats continue to negotiate, but Senate Majority Leader Mitch McConnell continues to cast doubt over the Senate’s willingness to support a large comprehensive package.  Despite this, Federal Reserve Chairman Jerome Powell continues to stress the need for additional fiscal stimulus to support the U.S. economy through the ongoing pandemic.  While economic concerns persist, market forecasts are starting to highlight a new challenge.

Vanguard and BlackRock both released their capital market assumptions recently.  Their reports analyze global economic and market conditions to forecast forward-looking returns over the next five and ten years.  Both reports suggest U.S. large-cap equity returns over the next decade will be approximately 5-6% annualized, significantly below their 50-year historical average of 10.1%.  The forecast for fixed income is not much better as the low yield environment will subdue future returns.  The forward-looking 10-year forecast for U.S. investment-grade bonds, represented by the popular U.S. Aggregate Bond Index, is at a meager 0.7% compared to a 50-year average of 7.3%.  For these reasons, advisors and asset managers across the country are working to adjust their client’s expectations of future returns. 

For years, the 60/40 portfolio (60% equity, 40% fixed income) has been a standard asset allocation.  The yield-generating lower volatility fixed income sleeve offsets some of the higher volatility and variable returns of the equity sleeve.  Using an overly simplified 60/40 portfolio of 60% large-cap U.S. equities and 40%. U.S. Aggregate Bond Index, we can calculate the potential impacts of these lower forecasted returns.  With a 6% equity return, and a 0.7% fixed income return, a 60/40 portfolio would generate an annualized return of 3.88%.  That number drops even lower once adjusted for inflation.

Traditionally as investors get closer to retirement, their 60/40 begins to invert to a 40/60, with some continuing to increase their fixed income holdings as they continue to age.  Investors typically reduce their equity holdings and increase their fixed income as they become more reliant on their portfolios to fund their retirement.  This will be a tough playbook to follow based on these forecasts.  The potential for investors to take on more risk than they can handle as they stretch for returns is elevated, especially for those in or transitioning to retirement.  We believe active managers can mitigate some of this risk.

Fixed income investments can benefit from active management for several reasons compared to simply buying a fixed income index.  The first reason is simply a byproduct of the fixed income market itself.  Whereas one share of a company’s stock is essentially no different than any of its other shares, a company can have several different bonds trading with varying characteristics.  Some bonds may be collateralized while some may be unsecured (no collateral).  Active managers are also able to seek out opportunities in pockets of the market that are less followed.  The added complexity of the market creates inefficiencies that lead to opportunities for skilled managers to act on. 

The forward-looking forecasts for the broad market reveal that some challenging times may be approaching.  Investors may find it difficult to achieve the same level of returns they have become accustomed to in the recent past.  The low-interest-rate environment is proving problematic to find sustainable income without taking on additional risks.  Furthermore, it is negatively impacting the role of fixed income as a risk reducer and volatility ballast in the standard 60/40 portfolios.  Active fixed income management may provide investors a fighting chance.  

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. Although general strategies and / or opinions are revealed, this post is not intended to, nor does it represent or reflect, transactions or activity specific to any one account. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All data and information is gathered from sources believed to be reliable and is not warranted to be correct, complete or accurate. Investments carry risk of loss including loss of principal. Past performance is never a guarantee of future results.

 

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