Is portfolio diversification, at least as traditionally practiced, a chimera?

Sébastien Page, head of global multi-asset at T. Rowe Price, said as much during a press briefing hosted this week by his asset management company.

The press briefing featured several T. Rowe Price investment strategists and portfolio managers discoursing on a range of topics. Page’s presentation covered a variegated landscape based on the top five charts he believes will matter for the markets over the next year.

One of those charts dealt with diversification across different stock, bond and real estate indexes. Page showed that, as in other major crises, correlations jumped and diversification failed during the depths of the Covid crisis earlier this year.

“The problem is diversification tends to work well when you don’t want it on the upside, and [performs] very badly when you actually need it on the downside,” he said. He added that with interest rates near the zero bound, shorter-term Treasurys aren't an effective diversifier versus stocks.

“But if the search for yield and return continues to push investors toward risk assets, and assuming they’re willing to accept the shorter-term volatility, diversification will become even more important,” Page said.

He proposed improving portfolio diversification by expanding the mix to include options such as long-dated Treasurys, absolute-return investing, hedging, and other diversifiers such as foreign exchange, gold and "perhaps" investment-grade bonds.

His basic take is that traditional 60/40 portfolios allocated 60% to stocks and 40% to bonds need enhancements, and that investors can modernize portfolios with risk-aware strategies.

“Our industry needs to rethink portfolio construction,” Page stated.

Pandemic
Elsewhere in his presentation, Page said the ongoing pandemic will weigh heavily on the markets—in ways both good and bad—for the foreseeable future. That was illustrated by last week’s big jump in U.S. equities after Pfizer announced very encouraging data from its coronavirus vaccine trial with its German partner BioNTech.

“The pandemic will perhaps continue to be the most important theme driving the economy and markets for the next six to 18 months,” he remarked. “In that context, as asset allocators we no longer start our discussion with the usual question: 'Risk on or risk off?' Now we add a second question: 'Covid on or Covid off?'"

He offered that likely beneficiaries in a Covid-on environment include growth stocks, large caps and technology companies.

“In Covid-off, we begin to see a potentially fast, great rotation in favor of the more typical economic recovery trade favoring small caps, value stocks, credit and so on,” he said.

Ultimately, Page said, the economy will accelerate after we get through the pandemic, and that progress in vaccine developments is key to moving to a Covid-off world.

Valuations
The huge rally in U.S. equities since the March lows makes them look expensive, but Page counters that Treasurys look even more expensive.

“The so-called equity-risk premium is alive and well at slightly above its historical median range since 1990,” he said. “Think of the market as a cash flow discounting machine. During Covid, rates went down by about 100 basis points, or close to 50% of their pre-crisis level. This alone could justify a higher price-to-earnings ratio.”

Stimulus
“Stimulus measures have been potent,” Page said, adding that pandemic-related fiscal and monetary measures have totaled an estimated $25 trillion globally, or close to half the total market cap of the global stock market.

In addition, the money supply has jumped more than 30% year over year, leading to questions about whether this will produce inflation.

In the current environment marked by high unemployment and GDP running below capacity, a large money supply could translate more into inflated asset prices than actual inflation in consumer goods, Page said, adding that much of this added liquidity has created a flood of cash on the sidelines in the form of money market funds.

“With so much liquidity, the market just wants to go up,” Page said. “The risk is that when the rate of change in the stimulus turns to negative, markets will become more fragile. We’ll need to see real economic and earnings acceleration to make up for it.”

Low Interest Rates
Page flashed a chart dated from 1983 to the current month highlighting the all-time lows in U.S. rates among the federal funds rate and 2- and 10-year Treasury yields. “The profound implication for people saving for retirement is that Treasurys don’t give you any compounding effect after inflation,” he said.

For instance, he explained, let’s suppose you put aside 10% of your salary every year and want to save for one year of pre-saving retirement income. Without compounding, you need to save for 10 years in order to save for one year in retirement.

“That’s what happens when you don’t have compounding working for you,” Page said. “Compounding has been described as one of the most powerful forces in the universe.

“With most retirees already underfunded, which means they don’t have enough money put aside, the math doesn’t add up,” he continued. “So not only will the search for yield continue, but the search for returns will intensify.”

Page noted that T. Rowe Price’s multi-asset solutions team estimates that to get a 6% expected return going forward, investors will need to hold more stocks than ever before. Depending on the assumption and the asset classes available, some investors might need a portfolio comprising as much as 80% stocks to get a 6% expected return, he said.