Disrupted supply chains in more and more sectors, inflation rates higher than they have been for almost 50 years and a downward trend in interest rates that is coming to an end: The coronavirus pandemic and the Russian invasion of Ukraine have caused a “Zeitenwende”, German for turning point, not only in politics, but also in the global economy and capital markets. How a multi-asset total return portfolio should look for this fundamentally changed environment was discussed by Klaus Kaldemorgen, portfolio manager of the DWS Concept Kaldemorgen, and Christoph Schmidt, co-portfolio manager and head of the multi-asset total return team, at the DWS multi-asset press event “How to invest in a new now” on Wednesday.
Inflation becomes a structural phenomenon
"The high inflation rates, so far mostly described as temporary, are becoming a structural phenomenon," Kaldemorgen said. A weakening globalisation will contribute to this, which will lead to lower productivity and higher costs, he said. At the same time, attempts to stop or at least slow down climate change would definitely not have a disinflationary effect. "Already in the past, central banks' monetary policy responses to such developments have ensured that a soft landing was the exception rather than the rule. Moreover, the monetary guardians are already well behind the curve," says the portfolio manager. To make matters worse, the loss of cheap energy from Russia and the necessary drastic increase in military defence spending have depleted the so-called peace dividend from which Europe and especially Germany have benefited for decades. "The macroeconomic consequences of all these developments are worrying. Consumer demand will fall because of inflation and companies will additionally suffer from falling margins and rising financing costs," Kaldemorgen predicted.
Profiting from dollar and gold
In view of the inflation trend and the previously historically low interest rate level, government bonds with long maturities are now extremely risky and have lost their function as a “safe haven”. At the same time, corporate bonds do not sufficiently compensate for the risk of deteriorating credit quality. "Against this background, we have shorted long-dated Treasuries and Bunds, which has given us a decent return from the bond portfolio in the first months of 2022," the portfolio manager said. Although bonds are not an attractive asset class across the board at the moment, short-dated Treasuries and dollar-denominated bonds of supranational issuers have recently been added to the portfolio. Two-year US government bonds are currently yielding around 2.6 per cent, which represents a reasonable risk-return ratio. The bottom line is that the strong dollar, along with the comparatively high gold position, also contributed to the performance of the DWS Concept Kaldemorgen. "Despite the headwinds from an expected tighter monetary policy and numerous geopolitical risks, however, equities remain in our view the asset class with the greatest earnings potential. That is why we are aiming for the highest possible share of equities in our portfolio. So the question is not whether to invest in equities, but in which ones," said Kaldemorgen.
Intelligently combined, equities can diversify like bonds
The great challenge is to construct an equity portfolio in which the individual components provide the diversification contributions that are indispensable for a robust portfolio across different market scenarios, but which can no longer be achieved with bonds, explained Christoph Schmidt. "The fact that equities and bonds also have different duration risks has been shown not least by the contrasting performance of growth and value stocks, where so far this year a minus of 22 per cent calculated in euros contrasts with a more or less unchanged level," said the portfolio manager. The division into the three thematic pots "growth", "stability" and "cyclical" has proven to be a successful approach for the corresponding structuring of an equity portfolio. However, these three components should not be naively weighted equally, but should rather be represented according to their respective risk contributions to the overall equity portfolio and in line with the current market environment. "In concrete terms, this means that we have recently increased the share of the 'stability' pot to around 50 per cent at the expense of the 'growth' and 'cyclical' pots due to the escalating Ukraine crisis, the expectation of tighter monetary policy and the uncertainties regarding the renewed corona lockdowns in China," Schmidt said. The focus is on defensive securities with attractive dividend yields, for example from the pharmaceutical and telecommunications sectors, which thus offer qualities that are no longer found in bonds.
Do not reduce growth values any further
Looking at growth stocks, the portfolio manager said that the valuation correction triggered by rising interest rates is likely to be largely over by now. "While the recent sell-off in the technology sector was not only due to interest rate developments, but also reflected concerns about the earnings outlook, we still believe that growth stocks should continue to have a substantial share in a well-balanced equity portfolio from our total return perspective. In the DWS Concept Kaldemorgen, it is currently around 25 percent," says Schmidt. At the same time, caution is still called for with cyclical stocks, which is why this basket is also the lowest weighted in the portfolio. "The energy and mining sectors in particular have recently benefited strongly from rising commodity prices and are often seen as inflation hedges. However, we believe this is a risky assessment given the risk of weakening macroeconomic momentum," he said.
Shares could yield an average of seven percent in the coming years
Klaus Kaldemorgen outlined what the combination of high inflation and rising interest rates could mean for the stock market in the coming years, using the 1970s as an example, which had been characterised by comparable conditions, mainly due to the first oil crisis. "Between 1973 and 1975, the market reacted strongly to this development, with US stocks falling by around 15 per cent. But the reason for this was a sharp tightening of monetary policy, which had catapulted the yield on ten-year US government bonds upwards to almost 15 per cent. But I think such a development is highly unlikely in this decade," says the portfolio manager. In the past ten years, global equity markets had then risen by about twelve percent p.a. in euro terms. "In view of the structural headwinds, I think we should therefore be satisfied if the stock markets would give us an average nominal return of seven percent annually," Kaldemorgen said.
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