Equities performed well during the pandemic, but could economic uncertainty dent their resilience? Andrew Holt reports.
The equities picture looks good, extremely good. But if you take a closer look, you will see that cracks are emerging. Global equity markets have received a substantial boost thanks to a combination of historically low interest rates and massive government stimulus launched in response to the pandemic, but there is concern that such favourable conditions are coming to an end.
“There has been a ‘tug of war’ between the economic damage caused by the pandemic and the unprecedented monetary and fiscal stimulus response by the authorities,” says Tom Joy, director of investments at the Church Commissioners, the body that manages the assets of the Church of England. “The economic environment remains uncertain and the impact of the pandemic remains uneven across the globe.”
There is no doubt that equities have benefitted in the tug of war scenario, but the economic and political uncertainty raises big questions about the equity environment going forward, especially when it comes to valuations.
One such note of concern comes from Craig Mitchell, an economist at workplace pension provider NEST. “Like the majority of investors, we are somewhat nervous about valuations,” he says.
A point also highlighted by Nick Moakes, chief investment officer at health charitable foundation the Wellcome Trust. “Valuations of just about everything are high,” he says. The positive equity picture has nevertheless significantly lifted the Wellcome Trust’s portfolio with valuations of its large technology holdings – Alibaba, Microsoft, Apple, Siemens, Amazon and Tencent – improving during the pandemic.
Adding to Mitchell’s equity worries is inflation. “There are some uncertainties, such as whether recent high inflation figures will be transitory or if it will prove persistent,” he adds. “Equity markets have risen a lot since the sudden drop in March 2020.”
Many eyes remain fixed on central banks and how they will respond to the evolving situation. “If investors start thinking central banks are complacent on inflation risks or that significant interest rate increases are imminent, then this would challenge equities and their performance,” Mitchell says.
Moakes is also guarded about the on-going environment and whether it will assist a repeat of the strong performance the endowment fund enjoyed during the last financial year. He expects global growth to remain sluggish predicting an “extended period of sub-par returns”.
But for all of this, Mitchell says there is also a case for presenting a more positive outlook, citing a strong recovery in global trade, which is already apparent, and corporate earnings growing rapidly as economies sequentially benefit from their respective re-openings. “If sustained, this gradually reduces the valuations concern,” he says, adding: “We remain positive on equities, as we hopefully continue to pass through the pandemic and economies start to re-open.”
In a similar way, the investment outlook for the second half of 2021 looks positive, at least according to one piece of analysis which predicts that the global economy will grow 5.9% this year and 4% in 2022, with equities set to outperform during the next six months to a year.
This is also evident in the MSCI World index of developed economy stocks, which entered June in record territory having gained 11% since January. Stronger gains have, it should be noted, been generated by companies in the energy and financial sectors – areas which have been lifted by economies re-opening.
Moreover, such short-term arguments and trends seldom bog asset owners down in committing to equities, which are a solid foundation of a portfolio in that they are long-term in outlook and could provide strong returns.
“Equities play an important role in our default growth fund, representing nearly 60% of the assets – across developed and emerging markets,” Mitchell says. “The asset composition of the default growth fund shows more than £9.4bn is invested in public equities across the whole portfolio.”
And when investors successfully embrace equities, this is borne out with effective numbers. The Church Commissioners’ public equity portfolio returned 18.3% compared to 13.2% by its benchmark last year – a substantial return.
“This successful active management continues the longer-term outperformance we have been able to achieve in global equities where our portfolios are ahead of the respective indices over five, 10, 20 and 30 years,” Joy says. No other asset class can, so consistently, deliver so much.
Equities will, therefore, remain a solid part of investor portfolios, albeit with on-going adjustments. “Public equity will continue to form an important part of our investment strategy,” Mitchell says. “Fundamentally, we think over the long term it offers good risk and return characteristics that meet our members’ needs.”
Neil Mason, who is responsible for the Surrey Pension Fund, is also bullish. “As an open scheme with positive cash ow forecasted for the medium-term investment horizon, we remain committed to equities making up a significant part of our portfolio,” he says.
And this is despite having recently adjusted the fund’s portfolio slightly. “We reduced our allocation to equities by 5% in our last strategy review,” says Mason. However, he notes an important proviso here: “We have slightly increased our allocation to private equity, so the net outcome has not seen significant change in the risk exposure.”
But while equities form a strong base for many asset owners’ portfolios, there is movement in the type of equities: with a big shift in the equity investment dynamic thanks to the increasingly important role played by environmental, social and governance (ESG) issues.
On recent portfolio adjustments, Mitchell reveals a strong climate-focused influence. “As of last year, we have introduced a climate tilt on all our public equity funds – in the default funds – to help reduce the climate risk within our portfolio, working towards our ambition of being a net zero investor by 2050 or sooner,” he says.
These climate aware strategies, which address a range of environmental, social and governance risks, track customised indexes, tilting investment in companies based on a score calculated on components such as energy efficiency, alternative energy and green properties.
“This means we will reduce investment in companies with large oil or gas reserves and those with a high carbon intensity, while increasing investment in clean technology and renewable energy opportunities,” Mitchell adds.
This is a trend followed by Surrey County Council’s pension fund. “We have sought to build in additional ESG metrics in our listed equity portfolio, whether this be through exclusions, an ESG tilt or a focus on engagement with consequences,” Mason says. “This matching the fund’s commitment to United Nations’ Sustainable Development Goals alignment.”
The climate agenda, in regards to equities, is also important for the Church Commissioners. “We use data from Trucost to monitor the carbon footprint of as much of our public equities portfolio as possible,” Joy says. “We compare our portfolio emissions with those of our globally-listed equities benchmark, which slightly changed in 2020 from previous years.”
This data indicated that at the end of 2020 the carbon footprint of the portfolio was 335 tonnes of carbon dioxide equivalent per £1m of corporate revenue compared to 222 tonnes for its benchmark. But this does not account for the climate-related investment restrictions that the commissioners announced in December 2020, which will radically adjust the picture further.
Furthermore, the Church Commissioners has set its first emissions reduction target that will put it on the road to a net-zero portfolio by 2050. This target covers the six years to 2025. “Our primary goal is decarbonisation of the real economy, which we actively seek to realise through engagement with policymakers and companies. Our vision is a net zero emissions global economy by 2050,” Joy says.
In addition, NEST has moved its developed market equity fund, which is managed by UBS, and its emerging market equity fund, managed by Northern Trust, into segregated mandates. Mitchell cites a couple of benefits: helping NEST implement its portfolio-wide exclusions, such as being tobacco-free, and giving it more control on how the portfolio strategy evolves.
“As an investor in a pooled fund you can try and influence fund strategy, but you do not have the ability to directly change it,” he adds.
Developing v emerging
There is also a regional debate here: developed market versus emerging market equities. “Emerging market assets form an important part of our portfolio, providing growth and diversification,” Mitchell says. “In the short term, there will be a range of different economic recoveries as it is a diverse asset class.”
But Mitchell says: “Over a longer horizon, we believe emerging market economies should continue to outpace the growth of their developed market counterparts, due in part to better demographics, a rising middle class and what is still a lower starting valuation compared to developed market economies.”
In addition, many Asian economies, including China and South Korea, also displayed extreme resilience in the face of the coronavirus crisis and appeared better equipped than most developed market countries – with significantly lower death rates reported. “We expect these economies to continue benefiting from their strong domestic handling of the pandemic and through benefits from resumption in global activity and trade,” Mitchell says.
As a result, for Mason, the emerging market picture is coming more into play. “We expect to allocate a higher proportion of our equity portfolio to emerging markets, although we are aware of the challenges that can present themselves with ESG in this area and will need to manage this closely.
“We also plan to work more of a regional allocation in our global portfolio, with more of a GDP index bias, to compliment the market cap allocation we currently hold,” he adds. The Wellcome Trust also has, for the first time, invested more in Asian equities than in Europe.
Ultimately, the equity picture may reveal problematical cracks, but it is the wider canvas investors are looking at: and that looks as solid as ever.