The US economy appears to be on a path to recovery after the massive dislocation caused by the onset of the Covid-19 pandemic in early 2020. Large scale vaccinations, a new $1.9 trillion stimulus package, and declining overall levels of infection have triggered renewed optimism among investors about the future of growth and financial markets.
But the path to normalization is not without risks, and investors should be mindful of potential asset-price volatility in the near future. Fears of higher inflation resulting from a re-ignited economy, for example, sparked a strong sell-off in Treasury bonds in March, boosting the yield on the 10-year note above 1.7% from about 1% in early February. Concurrently, belief in the so-called “re-opening trade” prompted many investors to rotate from high-growth stocks—which showed strong performance during the pandemic—to more cyclically oriented ones.
So, the question now is: What’s an investor to do?
We believe that a multi-asset approach combining equities and nontraditional fixed income has, historically, offered smoother returns in periods of volatility such as the one we see today. Based on more than 14 years of experience managing such strategies, we have found that a mix of US convertible securities, US high-yield debt, and US equities can offer a powerful solution for those seeking equity-like returns with less volatility than stocks while keeping a meaningful income stream.
Let’s contextualize this in our current environment. While it’s understandable that some investors are jittery about the rapid rise in US 10-year Treasury rates, it’s worth placing that in historical context: For the past decade, 10-year rates have moved between 1.5% and 3%. So, while the magnitude of the 10-year move (and its speed) is noteworthy, we view current rate levels as reverting to historically normal levels. Indeed, current rates are perhaps what investors should expect from a market that is starting to reflect an economy edging back to more normalized activity.
Investors that combine US convertible securities, US high-yield debt and US equities are seeking to generate upside participation and diminished downside relative to a pure equity allocation. So, how are market conditions in these three asset classes?
Two key themes dominate convertibles. First, convertibles had a strong 2020—returns topped 40%, its second-best year ever as measured by the ICE BofA US Convertible Index, only behind 2009, when the US was recovering from the Global Financial Crisis. In addition, new issuance was strong. The convertible universe was valued at less than $215 billion at the start of 2020, but with new issuance of over $100 billion and strong returns, it finished the year worth above $350 billion. The market also diversified beyond its concentration in technology and healthcare with new issuance coming from consumer discretionary and financial firms.
As new issuance continues, the asset class should continue to enjoy an asymmetric risk-return profile, typically capturing roughly 60% to 80% of the upside of the underlying equity and 50% or less of the downside. The first quarter of 2021 has already seen roughly $30 billion of new issuance and while we expect that pace to moderate, we still expect 2021 to be another strong year for new issues as companies take advantage of low financing costs and higher stock prices and opportunistically diversify their balance sheets.
High yield prospects also look positive for 2021 because of expectations of improved corporate earnings and stronger economic growth. Improving economies tend to lead to tighter credit spreads, benefiting high yield. Historically, when interest rates rise, high yield tends to outperform investment-grade credit and Treasurys because of its higher coupon and spread cushion.
The equities market has been dominated recently by some investors rotating from growth to value stocks and sectors that might do best in a re-opening. While we see some merit in that rotation, we believe that investors’ long-term focus should be on identifying firms with improving earnings expectations because, in the end, earnings are critical to generating outperformance. Firms that continue to meet or exceed expectations, should continue to outperform.
Investors should also be cautious about judging valuations based merely on price-earnings ratios, because for many companies, such as cruise lines and lodging/hospitality firms, earnings might not revert to trend until 2023. At the same time, investors should also take account of the interest-rate environment when considering valuations as well as the fact that the latest $1.9 trillion stimulus package is yet to hit the real economy. Until we get through this recovery phase, investors are unlikely to get clarity on the true earnings power of the US economy.
That said, companies’ cash positions are, on average, very healthy, especially those which used extremely low rates to issue fresh debt to shore up their balance sheets. In this light, we believe that conditions are in place for markets to see another wave of acquisitions in 2021 as companies utilize both their stock prices and debt to finance deals.
Overall, the outlook is positive with the tailwinds of improving earnings, massive stimulus and increasing M&A activity. Possible headwinds from inflation and higher interest rates are a risk, but on balance, we expect that investors should be rewarded for taking risk because tailwinds, at least for now, more than offset potential headwinds.
A column by Justin Kass, portfolio manager and managing director at Allianz Global Investors, responsible for the firm’s Income & Growth team