A typical balanced investor may have a 60-40 split between equities and fixed income, but these are not typical times. The way Philip Petursson sees it, conditions are very much “risk-off.”
That’s why Petursson, chief investment strategist at Toronto-based Manulife Investments, recommends that portfolios with neutral weightings of 60% equities should reduce their equity exposure. “Right now, we are recommending a 50-50 split. So we are underweight equity, overweight fixed income,” he says. “Everything comes down to the relative opportunity set that we see in the global investment environment across equity and fixed income and the drivers of each asset class.”
Petursson and two senior strategists regularly monitor the environment that drives earnings and valuations across equity markets within the United States, Canada, Europe and Asia ex-Japan. They also examine Canadian and global investment-grade bonds and high-yield bonds at home and abroad. As part of the exercise, the team consults with Manulife’s equity, fixed income and economics specialists around the world.
“It starts with the macroeconomic picture. Our work has identified a number of key indicators that help us build assumptions for forward returns for a 12-month period,” says Petursson.
One of the key barometers of earnings strength, or weakness, is the Purchasing Managers Index (PMI) in the U.S., Europe and Asia. “Manufacturing activity drives earnings. This is the first step and gives us an earnings picture within the equity environment for the next 12 months,” says Petursson. For the last two quarters, U.S. earnings growth has been negative, which Petursson says is not surprising given the direction of the PMI.
“For a long period, the PMI has been a very accurate indicator of forward earnings growth for the S&P 500,” says Petursson, adding that the team also studies U.S. export growth and inventory-to-sales ratios to determine global demand. “Based on our models, we expect to see flat-to-negative earnings growth in the second and third quarter. We don’t have enough data to support a rebound in the fourth quarter, but we think the environment is going to lead that way.”
Petursson believes that rising inflation and interest rates will put downward pressure on earnings multiples in the U.S. stock market. After combining earnings growth trends and assumptions about multiples, the team concludes that total equity returns for the next 12 months will be below the long-term average of 8%.
“We do not see a recessionary environment at this point,” says Petursson. “But we’re trading at 19 times earnings and expect inflation and interest rates will go higher. Assuming price-to-earnings multiples stay flat, the expected return will be a combination of the dividend and modest earnings growth — which is how we get to around 5%.”
Petursson’s conclusion is that the environment is quite balanced across equity and fixed income and also across geographic markets. “Canada has outperformed this year and there is an opportunity to continue to outperform over the next 12 months,” he says. “And the returns from fixed income — including high-yield and investment-grade — are very similar to equities. That’s why we have a 50-50 benchmark.”
The asset mix is considerably more conservative that the 70-30 mix that was recommended in 2014. One reason for the current mix is that there are greater sources of downside volatility than previously. These sources include the shift in bias by the Federal Reserve and the uncertainty surrounding crude oil prices and Chinese economic growth.
“We see greater sources of volatility which could skew or contribute to weaker results for the next 12 to 24 months, without the benefit of the upside,” says Petursson. “Put it this way: If you’re not going to be paid to take on the risk, don’t take it. If I can’t build the case for even average upside potential, let’s reduce risk in the portfolio.”
Although Petursson argues that investments should be held for the long term, he says it’s also critical to make tactical asset allocations that reflect market conditions.
“I don’t believe you should set an asset allocation, come back in 20 years and everything will be fine,” he says, citing as an example the five years ended April 30. During that period, the S&P 500 Index produced a compound annual return of 17.4% return in Canadian-dollar terms, versus only 3.1% for the S&P/TSX Composite Index.
“If you had remained overweight Canada, as many investors did because Canada had outperformed the U.S. leading up to 2010, you missed a fantastic return,” says Petursson. “Investors need to be tactical to take advantage of the opportunity set. It will not always be equal across geographies and I don’t necessarily believe in catch-up. Just because Canada underperformed over the past five years does not mean that it will outperform over the next five.”