Finding the winners as the pandemic fog clears
The best way to approach asset allocation is to broadly diversify through active management.
For the better part of 2020, asset allocation decisions have focused on the sectoral impact of the pandemic and the race to produce a vaccine to end it. Until vaccines are both manufactured and widely distributed, the worst impacted parts of the economy — travel, leisure, hospitality and retail — will lag, and in the face of uncertainty, bond yields will stay low and the dollar remain strong. However, the distribution of a safe and effective vaccine should be a catalyst for a reversal, at least in part, of these broad trends: cyclical sectors would outperform, bond yields would rise and the dollar would weaken. Now, with a number of highly viable vaccines potentially arriving much sooner than many initially anticipated, it appears that this shift has started to occur. The ultimate question investors must ask, therefore, is: how long does it typically take for this shift to occur, and is this most recent rotation durable or another head-fake?
During the three pre-pandemic economic cycles of the last 30 years — in this case, measured as spikes in the unemployment rate — it is possible to glean some general ideas about performance of major market indicators around periods of stress. The stock market is generally forward-looking, for example, and typically bottoms out before the unemployment rate peaks; but value stocks typically bottom roughly a month before growth stocks (four months versus three), with financials and energy typically hitting their lows five months before a peak, compared to technology’s three months and health care’s two. For investors looking at overseas assets, the dollar has historically strengthened for roughly six months following a spike in the unemployment rate. For investors looking at the bond market, both 10-year and 30-year yields took eight months after a peak to begin a move higher.
All of these things help to inform the asset allocation view for the duration of 2021. Assuming that a vaccine is indeed close at hand, investors can begin to think about where to rotate, and when.
For equities, investors would likely do well to begin a rotation into cyclical assets as soon as possible, with a particular focus on financials, though with an expectation of broad outperformance alongside the cyclical upswing. Depending on risk tolerance, investors may also consider rotating into international assets, though it should be said that until the pandemic is over, the U.S. dollar could maintain its strength. When looking overseas, European and Japanese markets should benefit from the cyclical upswing, while emerging markets, especially in Asia, will contribute to long-term portfolio growth. Finally, within bonds, investors should continue to position themselves in higher-quality, higher-duration assets for a ballast in portfolios, but should recognize that longer-end yields will begin to drift higher once the remaining slack in the economy is removed, leading to a reversal in this sentiment, perhaps as soon as the back half of next year.
All told, the investing landscape is both complex and changing. With the exact timing of vaccines still in flux, investors must be positioned for a fundamental shift in sentiment, and therefore target allocation, at nearly any moment. For this reason, the best way to approach asset allocation is to broadly diversify and work with active managers.