2021 Outlook: Prepare for post-pandemic portfolios

Key points:

• The pandemic is accelerating many secular shifts, redrawing prospects for industries and financial markets alike
• Low interest rates and elevated equity valuations point to lower five-year equity and bond returns
• But, equities, especially high-quality companies with strong growth prospects, should outperform bonds while offering a potential hedge against any inflation spike
• Private markets, hedge funds and gold may play a part in constructing multi-asset portfolios capable of prospering in a low-return era
• Similarly, investing sustainably could offer long-term growth at a time when governments and companies are promoting green investments in their recovery plans.

This year’s unprecedented events and the brutal economic shock sparked by the COVID-19 pandemic look set to profoundly affect the outlook for major asset classes next year and many more thereafter.

While many effects of the pandemic are expected to be transitory and fully contained in the medium and long-term due to the exogenous nature of the shock, there are other changes that are likely to be structural. With vaccinations looking likely to be rolled out across much of the world next year, the main question now is around the speed of the economic recovery.

But after the rebound, some areas of the economy will probably be changed for good. For instance, habits ingrained in the last year, like the surge in working from home and online retail sales, may largely stick after the pandemic subsides. In turn, altering prospects for many industries and economic sectors. Longer term, this could hit expected investment returns.

Prepare for a lower return era?

An analysis of prospects for leading economies and asset classes suggests that, at a time of record low interest rates and high equity valuations, total returns for the core asset classes over the next five years may be lower than seen in the recent past.

Bonds

The expected returns for developed market bonds look unusually poor due to the very low yield levels seen in many countries. Falling yields are heavily weighing on bond returns. For example, the nominal yields on 30-year government bonds in the eurozone and Switzerland are negative. Consequently, expected returns for government and investment grade bonds are negative.

In the US and UK, our analysis suggests that anticipated returns will remain positive, however recent downward shifts of the yield curve have compressed them below 1%. European and US high yielding bonds offer more attractive returns of about 2-4%. Nevertheless, when adjusted for inflation, the returns for lower quality bonds are also hovering a meagre 1% above zero. That said, if inflation were to climb for a sustained period, debt could post even lower realised returns.

Equities

Equities may find it tough to make substantial gains given their already elevated valuations on many measures, leaving aside how justifiable such valuations may be in terms of very low interest rates. The elevated cyclically adjusted price-to-earnings ratio hints at multiple contraction over the next five years. This may not occur in 2021 though, given that central banks should remain accommodative.

However, dividends and net buybacks of shares are expected to provide a stable income yield. Overall, developed market equities could offer nominal returns of 5-7% annually over the next five years. Emerging markets will likely provide a risk premium of 1-2% on top of that.

Equities to outperform bonds

While anticipated returns may be historically low, equities offer a decent investment opportunity due to their growth component. Compared to bonds, the asset class can act as a hedge in case of inflation and should still offer returns closer to their historical norm.

With central banks unlikely to tighten monetary conditions next year, and not much apparent scope for expansion, the onus for returns appears to rest on growth. In order to find opportunities for long-term growth, a focus on selecting high-quality companies exposed to secular growth trends, such as healthcare and technology, look attractive.

Additionally, the support for a transition to a low-carbon world seen from governments and companies of late, along with technology developments such as “smart everything”, are likely to offer prospects for long-term growth in a post-pandemic world.

Diversification to the fore

The low levels of volatility seen prior to coronavirus are unlikely to be repeated soon. While uncertainty levels should decrease, compared to last year, they look set to remain relatively high as the effects of the pandemic roll on and geopolitical tensions persist. This suggests that portfolio construction and diversification will matter more.

The diversification benefits of bonds have eroded in the low-rate environment. With income return prospects weak and limited scope for capital appreciation, the effectiveness of a portfolio invested 60% in equities and 40% in bonds is slipping. This seems to point to managing assets in a more tailored fashion to address investing in a time of lower return and higher volatility.

Alternative assets

In private markets, investment opportunities appear plentiful in both equity and debt universes. There seems little reason to doubt this will persist, offering the potential to aid portfolio performance. A high-volatility and low-return period could also favour hedge funds, notably in fixed income, despite their relatively poor performance in the last decade.

Depending on the strategy, hedge funds tend to be more or less correlated to equity markets. But even more so than in public markets, the dispersion in the hedge fund investment universe has increased. This means that an active investment approach in this space is of paramount importance for investors looking to produce alpha.

Finally, gold continues to appeal as a solid diversifier in a portfolio. With real rates low, and even negative in some places, the precious metal should continue to offer protection in case of rising volatility without being a drag on performance in quieter periods.

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