Andrew Pyle
April 22, 2022
Don’t throw out the balanced portfolio just yet
For many Canadians, the first quarter portfolio results will not be very appetizing, nor will they make sense. After all, the TSX index rose by just over 3% during the quarter (total return of +3.8% if we factor in dividend reinvestment), yet some balanced funds saw a net decline over the same period. If a fund had a greater weighting to non-Canadian equities, the performance would have been even worse. It might cause people to think that having a balanced portfolio doesn’t make sense anymore when, in fact, it is still going to be suitable for a large segment of the investor public.
Before we look at what has just taken place in this category of portfolios this year, let us first step back and review what we mean by the term “balanced”. The common conception of a balanced account is one where half is allocated to stocks and the other half is devoted to fixed income, which could be comprised of cash equivalents, bonds, floating-rate instruments and even preferred shares. In reality, a so-called balanced portfolio might have anywhere from 40% equity exposure to 60%. Therefore, said portfolio could have a fixed income weighting that is also 40-60%.
As I have discussed in recent commentaries, the bond market correction in the first quarter was profound and, depending on the sector we were looking at, it was the worst on record. Think about that for a moment. A bond market sell-off of 8-10% was the worst on record. Now, I don’t like an 8-10% correction in anything, more than the next person, but this is about a fifth of what the worst-case scenarios look like in equity land. If we were to use weather as an analogy, the bond correction just seen would be like a snowfall in June, where a similar drop in stocks would be like a November flurry.
One of the rationales behind a balanced portfolio approach is to produce a risk adjusted return profile that is appropriate for an investor that does not share the characteristics of neither an ultra-conservative individual or an aggressive one. Most times we expect bond and equity markets to move in opposite directions, such that the balanced approach creates a hedge or buffer against volatility. When stocks move higher (like when the economy expands and inflation rises), bonds will give way, but not to the extent that they counter the growth on the equity side. In contrast, if the economy contracts, then stocks will likely fall significantly, but some bonds will actually benefit and act as an anchor for the portfolio.
The problem arises when we have weakness in both equities and bonds. Now, there is no way I would label the first quarter as horrendous for stocks. As mentioned, Canadian equities did fairly well, but even the broader indices held up better than expected considering we had a European invasion and an aggressive tilt in terms of monetary policy in North America. The weakness in portfolio performance in the first quarter was driven more by bonds. In other words, the traditional balanced portfolio broke down. That doesn’t mean the portfolio, or the approach is permanently broken.
I would argue that it still did what it was supposed to and that was prevent an investor from feeling the full brunt of a large-scale correction in either asset class. In fact, one of the outcomes of the first quarter is that portfolios may have been pushed “offside” in terms of their equity versus fixed income allocations. Ally and I tactically added to this push in the first quarter by shifting capital from the fixed income model to equities after the equity pullback in January. We also boosted cash in the fixed income model and further reduced exposure to government bonds. This allowed us to limit the loss of capital in fixed income to about half of what the benchmark did. Now that we are one month into the second quarter, a different strategy within the balanced portfolio construct is needed.
First of all, it’s important to realize that the bond market has been extremely efficient at pricing in Bank of Canada and Federal Reserve tightening. Perhaps too efficient. At the time of writing, the 2yr US bond yield was sitting at 2.75% and the Canadian counterpart was just under 2.70%. The futures market is also implying a Federal Reserve overnight rate target of 2.75% by December and north of 3% by this time next year. If such tightening is realized, there is no way we will be talking about economic strength into 2023. Indeed, the probability of a downturn will move significantly higher.
That means two things for the balanced portfolio approach. First, we are entering a period where equity risk might need to be shaved back sooner than we previously thought. In some cases, this is simply going to be reducing exposure back to wherever the line in the sand is for that balanced portfolio; but we suspect it has to go beyond that. Indeed, we are already starting to build cash in the equity model as we move into May.
On the other hand, the bond market looks extremely oversold to us after the sell-off in the first quarter and April, especially on the lower risk spectrum of the market (i.e., government bonds and investment grade corporate bonds). This doesn’t mean a complete overhaul of the bond model, but it does suggest that it’s time to start layering in lower risk bonds. Yields are definitely more attractive in this space than at the end of last year, but there is a defensive reason for making a shift. If the economy does start to buckle under the weight of higher rates, then anticipation of further central bank tightening will diminish. That should put a cap on bond yields. If economic forecasts deteriorate to the point where a recession looks likely, then the market will have to start thinking about what central banks will do. In other words, will rates have to be cut? In that case, government bonds would probably rise in value and provide a cushion to the balanced portfolio at a time when equities aren’t looking so hot. This is what a balance is supposed to provide.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew
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These are the personal opinions of Andrew Pyle and may not necessarily reflect those of CIBC World Markets Inc.