Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Life for equities after the ‘three Ps’
Life after what American Century Investments (ACI) calls the three Ps – the pandemic, Putin and Powell – hasn’t gotten any easier for equities managers, even as a new FOMO rally creates the illusion of a global economy in rude health.
“Technology has regained its leadership and energy is at the bottom of the board,” Brent Puff (pictured), senior portfolio manager at ACI, told media on Wednesday. “You can see a real reversal in leadership, which caught us pretty by surprise. Another hallmark of the market, which is more a US phenomenon, is the narrowness of the rally in the S&P500.
“If you look at the per centage of stocks in the S&P500 that are outperforming the index year-to-date it’s at a 20 to 25-year low. Through the middle of June the five best performing stocks in the S&P500 contributed 80 per cent of the index’s return.”
The performance differential between the equal-weighted and cap-weighted indices is “unusually large” and it’s American Century’s view is that it’s going to be difficult for the market to move meaningfully higher so long as inflation stays above central bank targets, like it is in much of the developed world, and as the global economy continues to decelerate.
“Recession or no recession, it’s our judgement that the rate of economic activity moving forward is likely to continue to slow,” Puff said. “We’re more worried about the trajectory of economic activity than the impact of higher inflation and higher interest rates. In our opinion equity markets have already absorbed most of the headwind associated with higher interest rates and higher cost of capital.”
“If you look at equity valuations in the United States for example which were by global standards more stretched than most through the Covid period, in a period of about eighteen months the overall market multiple unwound nearly the entirety of what was a two standard deviation Covid spike… Equity valuations still by historical standards look pretty reasonable.”
But the overall environment in which companies are operating is going to be dominated by slower economic activity, and that’s going to make for a more challenging backdrop for companies to grow their earnings and value. It’s not the “most rosy, optimistic outlook”, Puff says, even if most of the valuation pressure has played out.
“We’ve had a lot of tightening over a short period and in our opinion the impact on the real economy is only really starting to play out today,” Puff said. “That’s what we’re worried about; we, like many people, have been surprised by the resilience of the US economy in spite of these headwinds.
“A good description of what it feels like is happening is we’re slow walking into a recession or a period of time where growth is going to continue to lose altitude. The consumer has been the glue that’s held the US economy so far and if you look at the consumer today you’re seeing a bifurcation; low end consumers are clearly struggling, and retailers that serve them are generally struggling. But overall consumer spending has been stronger and more resilient than expected.”
