It is a hard truth of investing that the biggest downside risk to the investor is themselves. While high inflation, market crashes, and pandemics can all create short-term disruptions to the progress of your portfolio, permanent damage tends to occur when we make poor investment decisions.
Such decisions tend to occur when we allow our emotions to govern our actions and tend to fall into two main groups.
1. The first is driven by overconfidence, optimism, and a belief that recent high returns can be replicated in the future. This can lead to investors over-paying for an asset and never achieving a return as optimism evaporates and the price reverts to a more realistic lower value. The technology boom and bust at the turn of the century is probably the best known recent example of this, however, new examples occur almost every day.
2. The second is driven by fear and occurs when investors sell holdings following a crash. By doing so, they realize losses that would otherwise have been erased in a subsequent recovery. The recent experience of investing through the pandemic is a great example of this situation.
The challenge for investors is that markets are cyclical and so are the emotional pressures. Investors want to buy when prices are high and sell when they are low. Combatting these emotional pressures requires a strong investment process and the ability to think independently.
Apart from this, there are a few near-term risk factors that don’t seem to be priced in the market valuations. Many market participants are still encouraged by the economic recovery, with strong corporate earnings and cheap interest rates, so continue investing full throttle. Others are beginning to question the durability of the recovery and earnings growth, the likely impact of the new covid-variant, high inflation driving central banks to reduce monetary stimulus, FPI outflows, and market valuations.
The Morningstar Investment Management team has come out with a report to guide investors on how to position their portfolios in 2022. The detailed report with visuals and data can be accessed here.
Meanwhile, here is the asset class positioning of our managed portfolios in India.
In our view, equities are benefiting from expectations of an economic rebound. If we look at the GDP numbers, India is expected to exceed pre-pandemic levels by the end of FY 2022 with GDP likely to grow at 9.5%. Technically, the economy would then move from the recovery phase to the expansionary phase. Also, a few other drivers that bode well are thrust on capital expenditure, improving exports, and expectations of increased consumer spending. These growth drivers are expected to help corporates improve their earnings fueling a stellar rally in equity markets. Higher market valuations point to lower equity allocations and more defensive positioning overall. But the economic recovery has been decent, and corporate profits are rising quickly.
From an investor’s perspective, we see this as a classic recovery plot, with equity investors frontrunning the economic recovery – taking the driver’s seat, while corporate earnings pick up. However, in the near term, a few risk factors (mentioned above) linger. Lately, local markets are off 4%-6% from their recent peaks.
At a broader level, domestic equity allocations in our portfolios remain near target levels with a slight underweight on the overall position. At a market cap level, we favor large-caps over mid and small caps with an overweight position on large-caps vs our target allocation. Whereas we are underweight mid and small caps amid valuation concerns.
In the case of U.S. equities, the strength of the economic recovery is leading to fundamental improvements with corporate profits continuing to rise. However, we must recognize that much of the recent rally was sentimental optimism, with valuation concerns festering. At current prices, U.S. equities still look expensive overall, according to our analysis, both in absolute terms and relative to international markets.
European stocks also enjoyed a strong period as economies opened up. This has helped lift European corporates, many of which had long suffered from sluggish revenue growth. Inflation and valuation concerns are also less of an issue here, supporting prices.
On the other hand, Emerging-markets stocks have had a difficult run, with meaningful losses in some markets. Part of the reason these stocks have lagged is influenced by Chinese regulatory headwinds, with some of the largest technology companies under the microscope and weighed down by heavy fines. However, inflation is also a major challenge across the board, triggering a general rate hiking cycle in many emerging markets and causing nervousness among emerging market investors.
We consider emerging-markets equities, despite recent moves, to be among our preferred equity regions (alongside the U.K., and European equities) on a relative basis. Accordingly, we continue to maintain an overweight to non-U.S. stocks, particularly in Europe and Emerging Markets. Within EM, as the Chinese tech giants corrected, we saw an absolute and relative valuation opportunity and added exposure to Chinese equities through a dedicated China fund.
Our asset class research suggests that going ahead, investors will struggle to post significant gains in bonds as we are around the turning point of the current low-interest rate cycle. The annual return expectation from bonds would be more normalized as compared to high teen returns delivered in the last couple of years. From a long-term perspective, we think bonds remain a necessary stabilizer for multi-asset portfolios, and medium-long duration bonds are likely to provide a cushion when equities sell-off as they offer attractive real rates. Based on our valuation implied return (VIRs) forecasts, the medium to long-term debt segment 5-10 years maturity looks relatively more attractive than cash and high credit quality short-term debt. Accordingly, we are overweight medium to long term segment of the yield curve as it offers attractive real yield vs cash and short-term debt.
On the corporate bond side, credit spreads have also narrowed lately, compressing the net of expenses yield difference between banking PSU debt funds and credit risk funds. Although the absolute return expectation for credit risk is slightly higher due to better carry. However, one should be mindful of potential downgrades and defaults and their impact on the credit spreads which needs to be monitored carefully.