The risk of a correction is rising

It has been almost a year since news of a successful vaccine against Covid-19. In that time, the MSCI World Index has risen some 20% while any dips have been shallow and short-lived. 

Investors' enthusiasm won’t last forever. However, for now, we are sticking with our overweight allocation to equities. The key reason is that both GDP and corporate earnings should continue to grow, providing fundamental support for the asset class. After a dramatic rebound in earnings this year, companies are on track for a year of solid, if unexciting, earnings growth in 2022. We also continue to see pockets of value within stock markets, as well as compelling growth opportunities.

A foot in both the growth and value camps

The strong recovery from the pandemic paved the way for a dramatic comeback for more cyclical sectors, after years in the doldrums. However, over recent months it is growth sectors that have once again taken the lead. This has rewarded our decision to maintain our overweight allocation to technology and healthcare, which we think continue to offer a multi-year opportunity. We also maintain our carefully selected exposure to more cyclical sectors.

These should start to perform more strongly as fears over the delta variant subside. In case this takes time to materialise, we have tilted our exposure towards higher quality companies with healthy balance sheets.

Rising risks of pullbacks

The early months of an economic recovery tend to be the best for equity markets: the transition to a period of lower growth can be tricky, as investors question the strength and durability of the expansion. Equities can continue to deliver attractive returns, but the path tends to be bumpier. We may well be entering such a phase now and we are therefore maintaining our exposure to defensive and diversifying assets. These can help protect portfolios during equity market drawdowns and reduce overall volatility.

Lower returns as economy transitions to next stage
of recovery

S&P500, average cumulative return (%) in different phases of market cycle

^{Source: Goldman Sachs. Returns from S&P500 since 1973. The “hope” phase of the market cycle typically starts in recession, as investors anticipate economic recovery.}

Inflation makes diversification trickier

The prospect of inflation closer to 3% rather than 2% could create a more challenging environment for conventional government bonds – traditionally the key defensive asset within portfolios. We have therefore reduced our position in conventional bonds in favour of inflation-linked bonds, which have defensive characteristics while also offering inflation protection. We have raised our exposure to high-quality credit as a way to enhance returns from our defensive assets without significantly increasing risk. Lastly, we have slightly  increased our allocation to hedge funds. We are focused on funds that can generate attractive returns with low correlation to equity and bond markets.