As markets price in potential interest rate hikes next year, there are implications for investors’ portfolios. Anthony Okolie speaks with Jing Roy, Portfolio Manager, TD Asset Management, about what investors could expect from bonds and equities and how to navigate market fluctuations.
So right now, I see three things that really stand out to me. First of all, the economic recovery is really starting to gather steam. We're seeing unemployment rates start to fall faster than before, and we're seeing a pickup in service demand rapidly as the vaccination rates start to go up. So especially when we see the positive readouts from the two antiviral pills, we're finally entering the endemic phase of the pandemic and on track to a full normalization. And the second thing I see is that inflationary pressure is stronger than people expected, and that's largely a result of very strong goods demand, supply chain constraint, and higher energy prices. But let's not lose sight of the fact that the inflation expectations five years out is still anchored at the pre-pandemic levels. So that's very important because that's really dictating the central bank policy reaction function. And lastly, given the robust recovery in hiring inflation, we're seeing central banks start to withdraw policy support and quantitative easing is being gradually phased out and we're seeing increasing number of hikes currently being priced into the bond market.
OK, so given this backdrop, we've heard the inflation story, we've heard tapering. What are the investment implications for investors going forward?
Against this backdrop of higher inflation, less accommodative monetary policy, investors are more likely to see lower investment returns and higher asset correlation going forward. So what does this mean? Inflation is eating into our investment returns. While our grandparents were able to retire on investment interest incomes 25 years ago. Today, if you were to invest in the US Treasuries, you'll be falling behind inflation by 37%. That's a staggering number. And on the other hand, equity returns is going to be more muted. And that's the function of valuation model of being capped by the very high expectation from the central bank. And also, the earnings growth will likely cycle through tougher comps next year. So with that, investors may have to kind of settle for lower returns. Besides lower returns, we also have to see that bonds is a bigger issue here because bonds will cease to provide diversification in a higher inflationary regime. Right now, we're seeing bonds can provide inflation when there's an equity drawdown. But in a higher inflationary environment, you cannot count on that. As a result, people will have to dial back their equity risk exposure and as a result of lower returns, if they're not comfortable with the variability of the returns in their portfolios.
OK, so I heard a lot of things there about inflation and certainly lower returns. What do you see as a key investable theme that investors should focus on next year, particularly as we start to see potentially higher interest rates?
Well, I see three broad investment things. First of all, I think the high quality growth is still in the name of the game. Well, stocks, really, if they can consistently beat the expectations provided by market, they are better at overcoming the inflationary pressure and multiple compression to deliver capital growth. And typically, those stocks come from technology and healthcare sectors because they enjoy the strong secular tailwinds. And secondly, stocks that pay and grow dividends consistently and sustainably will play a bigger role in the portfolio when capital gain has become more muted. Now, on a sector basis, that points to banks, pipelines and selective rates. And lastly, because the cyclical recovery is shifting from goods to services demand, so there are still pockets of opportunity within travel and leisure, as well as the cross-border payment sectors.
OK, so based on these themes, what are the new tools that can help investors navigate this post-COVID-19 environment?
Well, no doubt this is becoming a more challenging investment environment. So it's very important for us to see our portfolio through a new lens. To start off, portfolio construction is critical, but often it's an overlooked driver in investment return. Besides the pure bottom-up stock selection, there's a greater need for us to curate a portfolio of stocks to actually have access to different sources of return when bonds can no longer provide effective diversification. Next, we need to look beyond traditional equity and bonds. You are to secure returns without having to overreach for risk. So in our toolkit, we can use options, hybrid securities, currencies to manage equity drawdown. Drawdown management is extremely important because for investors who avoided the 10 worst case of equity drawdowns of past 25 years, they're twice as well off as those who simply bought and held. We also need to invest in real assets and private equity like instruments in order to help us smooth out the path of investment returns and help us stay invested during periods of volatility.
OK, so given all that, what are the key takeaways for investors to focus on going forward?
We're now entering a period of higher inflation, less central bank accommodation and ultimately lower returns. But we see investment opportunities in high quality growth stocks, dividend compounders and cyclical services sectors. Because of the shifting investment landscape, we really need a new perspective and new asset classes to help us stay invested, stay the course and secure our financial future.
Jing, thank you very much for your insights.