Think you’ve seen it all in the 2020 stock market crash and subsequent rebound for the ages? What’s ahead for investors may rival that. Serious inflation, unseen in decades, is a threat. So are higher interest rates and an end to the era of strong gains for both stocks and bonds. I talked this week to Kurt Reiman, chief investment strategist for Canada at global investing firm BlackRock, about what’s ahead for investors. Here’s an edited transcript of our conversation, which took place after the release of BlackRock’s investing outlook for the second half of 2021.
Let’s start with inflation, which has emerged as a top investing concern. BlackRock’s second-half investing outlook predicts higher inflation in the medium term – can you flesh that out for us?
Over the medium term, say over the next several years, we see a higher inflation environment emerging. One thing we can say with greater certainty is that we don’t think the postfinancial-crisis playbook is going to repeat itself. Meaning, the slow growth, disinflationary, supportive monetary policy environment lifting valuations of both stocks and bonds is unlikely to reoccur. Rather, we see greater variability in potential outcomes. One of those is potentially a higher inflation environment than we’ve experienced in our investing lifetime.
True – we have a generation of investors who have never had to contend with inflation as a serious threat. How nervous should people be?
Higher inflation matters importantly for investors. If you’re holding cash or government bonds, yields are so low today that they’re not keeping pace with inflation. So the purchasing power and the intended portfolio resilience to inflation is more limited. We have to find other solutions.
Let’s say I have a conventional 60/40 portfolio of stocks and bonds – what tweaks do I need to make to adjust for rising inflation?
In the near term, meaning our tactical investment horizon over the next six to 12 months, we’re doing a few things. The first is reducing our exposure to government bonds even more. We were underweight, now we’ve decreased that underweight. And, we’ve increased our allocation to inflation-protected bonds. Another step to limit inflation impact is to overweight stocks – we’ve done that. Within stocks, we would lean into, for example, U.S. small caps, which have an increased allocation to cyclical sectors like energy, materials, financial and industrials. We have also migrated our geographic preferences to regions of the world … where growth momentum is picking up. For example, Europe and Japan.
Canadian and U.S. stock indexes have produced big double-digit gains in the past 12 months. What do you tell an investor who is afraid to put money into the stock market today because share prices have come so far, so fast?
Prices have risen, earnings have risen more. So valuations have not become extended. The valuation framework we use is the equity risk premium, which accounts for the low level of interest rates. By that measure, when we look at U.S. and Canadian stocks, we don’t see them as being particularly expensive. In fact, they’re right around their historical fair value.
From here, after the market surge of the past year, what do you consider to be a reasonable 10-year average annual total return before fees?
We would very much push back against the idea that investors are going to continue to receive returns in their stock portfolio that they received in the recent past, and even in the past decade. For U.S. equities over the next 10 years, I think an expected return of 6.7 per cent seems reasonable, and that’s in Canadian dollar terms. For Canadian equities over the next 10 years, we have it pegged at 5.6 per cent.
Have you spotted any sectors in today’s market that are undervalued?
Demand for energy is coming back online faster than supply is being brought back, resulting in higher prices that we think can be sustained. It’s interesting to note that Canada is well positioned here. We see that earnings estimates for the energy sector are above where they were before the pandemic, which is not the same as in the U.S. I would identify financials in Canada as another area. Financials may not be cheap relative to their own history, but the sector is cheap relative to the broader TSX.
The S&P/TSX Canadian Dividend Aristocrats Index has outperformed the Composite Index in the past year. In an inflationary world, are dividend-growth stocks one answer?
If we’re right and interest rates are moving higher, that would tend to penalize some dividend-yield sectors. But if you can get dividend growth, I think that’s a perfectly fine approach. In a more compressed total return environment, this is something that investors do need to target.
You highlighted China in your outlook. Does the typical Canadian investor need exposure to China?
The question is, do investors want exposure to a rather fast-growing, key part of the global economy, where currently the market cap of the Chinese equity market and the Chinese government bond market is a considerable distance away from the weight that the Chinese economy has in the global economy? All of these things argue for a specific China allocation, but this is a decision that should be made on a case-by-case basis.
The introduction of the cryptocurrency exchange-traded fund has greatly simplified the process of investing in bitcoin and other cryptocurrencies. What is your view on a portfolio allocation to crypto?
I don’t think an allocation to bitcoin and other cryptocurrencies makes sense strategically because it’s hard to identify the cash-flow stream that enables you to judge the valuation.
Investors are really struggling with bonds – they understand the function bonds perform in acting as a hedge against stock market plunges, but yields are low and bond prices have fallen this year. What’s the best way to get your fixed income exposure right now?
The first approach is to shorten duration [by focusing on bonds maturing in the short term, usually meaning five years or less]. I would then ensure a reasonable allocation to corporate bonds, by virtue of the fact that they offer higher income [than government bonds]. I would also consider putting a portion in inflation-linked bonds. Part of the struggle is needing to be more active within the bond market, to be making decisions about where to have exposure. This requires quite a bit more due diligence than the kind of set-it-and-forget-it approach that investors used from the early 1980s to, basically, now. Fixed income is still a critical part of the portfolio, but it requires more attention than it did in the past.
Are we at an inflection point for not just fixed income, but all investing, in terms of it getting harder?
I think harder is right. It’s going to require investors to dig deeper to understand the outlook and where the opportunities lie. For Canadian aggregate bonds, our mean expected return is 1.7 per cent over 10 years. Mix that with a return for equities that is a fraction below 6 per cent, add inflation and we’re talking about returns in the low single digits.
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