How to position your portfolio

By Dhaval Kapadia |  12-01-22 | 

Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble. – Warren Buffett

During the height of the pandemic-induced sell-off in March 2020, we were in an environment where opportunities were plentiful, and a very targeted approach wasn’t required. Today, the situation is different. Investors ought to take a more measured approach to constructing their portfolios: i.e., put out the thimble, and save the proverbial bucket for a period with heavier rain.

Investors entered 2022 with stocks at or near all-time highs. Sharp gains across risk assets such as equity and credit have left investors with only a small number of investment opportunities. That requires an increasingly focused approach to portfolio construction.

The Morningstar Investment Management team has come out with a report to guide investors on how to position their portfolios.

The detailed report with visuals and data can be accessed here. Below is an extract by Philip Straehl, Global Head of Research, on the importance of portfolio positioning.

When assessing the number of attractive asset-class opportunities, we tend to look at the percentage of assets that trade above their fair return, which is the return we expect to realise when the asset is trading at fair value.   The number of assets that are fairly valued based on our valuation models has declined since last year. For instance, in March 2020, 57% of all country-equity markets that we track traded at a discount to their intrinsic value, and that has fallen to only 6% of all country markets as of the end of October.

Because of the scarcity in opportunity out there, the work that our global investment team does to uncover the opportunities presenting the best potential reward for risk becomes more critical. Looking ahead to 2022, we are highlighting three investment ideas for investors to consider in their portfolios.

  • The Recovery Play
  • Relative value in Energy and Financials

While there are a number of headwinds on the horizon, not least uncertainty about inflation and the emergence of a resistant COVID-19 variant, the global economy is poised to continue its recovery, fueled by the normalisation of economic activity globally.

At current prices, global equities look expensive overall, according to our analysis, both in absolute terms and relative to international markets. However, there are pockets where we continue to see opportunity. These opportunities tend to cluster in more cyclical (or economically sensitive) areas of the market—including energy and financials, which have both done exceptionally well recently.

Energy stocks and financials also have attractive inflation-fighting properties, given their ability to pass on price increases to their clients. Inflation tends to boost interest rates and a steeper yield curve, which benefits banks. Oil is a commodity, and any price increases are passed on to consumers. In the event of a continued rise in inflation, energy and banks stand to benefit.

  • Growth Companies at a Lower Price
  • The case for China tech

Investors have been bidding up prices of so-called “big tech” in recent years amid scarce growth elsewhere and falling interest rates, propelling an increase in stocks with the prospect of long-term growth. This run-up in prices, in addition to the risk of stretched valuations, has also increased concentration of the U.S. equity market in a handful of technology companies. As of September 2021, Meta Platforms (Facebook), Amazon, Apple, Netflix, Google (Alphabet) and Microsoft made up approximately 24% of the US market, creating a need for U.S. investors to diversify away from single stocks.

A sell-off in Chinese equities over the course of 2021, which was triggered by a regulatory crackdown, presents investors with an opportunity to purchase shares of big-tech companies at low valuations. At current prices, China appears to offer better absolute and relative value than any other major market, even after accounting for the potential impact that the regulatory crackdown may have on growth and profitability. Chinese stocks have an attractive growth profile and the major tech names have low financial leverage, which provides diversification against some of the cyclical stocks that are also trading cheap.

Therefore, we think there is a growing case for investing in China.

  • Emerging-Market Debt in Local Currency
  • The only place for positive real return in fixed income

With negative yields on government bonds (after adjusting for inflation) across developed government-bond markets and corporate credit spreads at multi-year lows, returns from the fixed income universe appear paltry over the next decade. Emerging-market debt in local currency (which we prefer over hard currency) continues to offer positive real yields and is a notable exception.

Our view remains that emerging markets’ sovereign fundamentals are broadly stronger than in the past. Improved current-account balances, enhanced reserves, movement to orthodox monetary policy, and a build-out of a local investor base allow for a shift to local-currency funding, though there are ongoing concerns surrounding an increase in debt levels and a lack of fiscal discipline in some countries.

In aggregate, emerging markets (EM) were slower out of the blocks in opening up their economy than developed markets (DM) were. That said, the majority of EM central banks have started increasing central-policy rates as inflation remains elevated. In addition, an aggregated view of EM currencies also looks undervalued and should be a tailwind over time. The area can be volatile, yet even allowing for some pessimistic assumptions, our research suggests that investors could earn a decent premium over similar-duration U.S. Treasuries if they’re willing to risk short-term loss. Stated differently, we think investors are likely to be compensated for the risk of investing in emerging-markets bonds over time, especially for local-currency bonds.

Access the detailed report with visuals and data.

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