Key Highlights:

  • With increasing vaccination in most developed nations and a gradual economic recovery shaping up, Q1 2021 saw a broad market recovery with equities outperforming fixed income, but with rising volatility. This highlights the importance of diversification.
  • The expectations of an economic recovery generate concerns about inflation. This caused interest rates to rise on the long end and steepen the yield curve. Central banks have stated they are likely to keep interest rates lower for longer.
  • Endowus Cash/SRS portfolios have generated better than market returns for portfolios with equity allocations. The Balanced (60-40) portfolio had outperformed the index by 1.58% over the quarter despite many commentators predicting its demise, after a stellar year in 2020
  • Value and small factors came roaring back in Q1 and interest in the long term factors of returns are increasing.
  • Despite many predictions of the demise or death of the 60-40 balanced portfolio, last year was a stellar year of performance and the importance of diversification is strengthened by the Q1 performance.

The Endowus Investment Office Q1'21 Market Commentary

The Road to Recovery

Growing expectations of a normalisation of the economy and our daily life has been a defining characteristic of the first quarter of the new decade. A day does not go by without the media commenting on the progress of vaccine drives globally and how soon the world may achieve herd immunity and some form of normalcy. Financial markets since the COVID-19 outbreak has been anything but abnormal.  

Despite massive volatility initially, both equity markets and fixed income markets generated  great returns.  Q1 2021 was dominated by rising bond yields and a value-led equity market rally. It is now just over a year since equity markets bottomed and MSCI World has rallied 79% since then.

This is the first quarter in which we are seeing meaningful volatility. This is especially apparent on two fronts. Firstly, in the emerging markets, where equities rallied hard and are now taking a breather. Secondly, in the fixed income markets, as investors grapple with the multiple potential paths to recovery possibly including an inflationary outcome. This has led to rising interest rates and falling bond prices.

Market volatility proves diversification matters

It has been remarkable thus far when we look back at the speed of vaccine development and its deployment. The US has surpassed 3.5 million vaccinations per day and Israel achieved records in vaccinating its entire nation. However, it will take much longer to achieve herd immunity for the majority of developing nations while a few developed countries raced ahead in their vaccination efforts. Nonetheless, the start of the decade bodes well for a sustained economic recovery although we may see some bumps along the way.

Percentage of citizens that received at least a dose of COVID-19 vaccine

Source: ourworldindata.org

Economic recovery has picked up pace, albeit from an extremely low base, and there are now rising expectations that increased vaccinations will accelerate the pace to normality. Rising manufacturing, trade, and service sector recovery will drive stronger growth. This will help companies drive global earnings per share (EPS) recovery which will help normalise valuations somewhat. However, the market is forward looking and pricing in this recovery.

Earnings recovery needs to keep pace with market expectations

Source: MSCI, Bloomberg Finance L.P., Fidelity Investments (AART), as of 31 March 2021

Herd Instincts drive certain asset classes

Despite rising volatility in some asset classes such as emerging markets and the fixed income markets, there has been strong performance globally in equities. The first quarter showed the importance of being truly globally diversified and not putting your eggs in one basket such as one country or a sector or asset class, like Chinese internet or gold.

There is market chatter of stock bubbles forming as we reach new highs in many asset classes. The leakages of the abundant liquidity to real assets, such as commodities, real estate, and even cryptocurrency has been a salient feature of the first quarter. We have also seen massive first day pops in IPOs of tech companies and SPACs galore. This is against the backdrop of rising property prices but it pales in comparison to crypto and speculative stocks such as Gamestop. However, a key laggard has been gold, underperforming silver and other real assets meaningfully.

It’s true that we have also seen major busts such as Archegos, which is a stark reminder of the realities of market risk. One thing is certain - volatility is back. It is easy to say that investors were driven by herd instincts and have all hurried back into investing in multiple growth and real asset classes with rising optimism. In finance, herd instincts is a phenomenon where investors follow what they perceive other investors are doing, rather than following their own analysis and that is exemplified by things like the Reddit army and Robinhood crowd investing phenomena.

Signs of a bubble? The rise and rise of cryptocurrency & speculative stocks

The movements of some of these highly speculative investments, especially in growth stocks of technology-related sectors, have led to an increasing comparison with the Tech bubble of 1999 and many asking if there is a bubble forming in the market. This obviously also leads to worries about the bubble bursting and that we are about to experience another collapse in financial markets. However, it is important to understand the long term trends in markets and what growth asset classes have done and it is important to remember that we have actually experienced two 20%+ corrections in equity markets in 2018 and again in 2020.

Endowus Q1'2021 Portfolio Performance

Overview of the Performance

The Core Endowus Advised Portfolios have mostly outperformed the broad markets in Q1 2021. For the 100% equity portfolio, it generated 8.47%, outperforming the benchmark MSCI All Country World Index by 2.07%. For the Balanced 60-40 portfolio, the returns were 4.38%, surpassing the composite 60-40 Index by 1.58%.

Our selection of fixed income funds slightly lagged the Global Aggregate but better than the Emerging Market returns which was particularly weak. However, this follows a very strong performance for the full year 2020 when the portfolio returned 6.1% compared to the Global Aggregate benchmark return of 5.4% and the EM Bond index of 5.9% despite the volatility the fixed income markets exhibited during the March correction.

Q1'2021 Performance of Endowus Cash SRS Core Portfolios

With the Endowus Cash and SRS Core portfolios having a tilt towards the long term proven factors of returns, it is important to update you on the rotation we have seen.  The rotation has resulted in our portfolio outperforming meaningfully during the first quarter due to the value, small and quality factor exposure.

The Fama French factor model is a capital asset pricing model that focuses on size(small), value(cheap), and quality(better) factors to the market risk factors. The model was developed by Nobel laureate Eugene Fama and his colleague Kenneth French in the 1990s. Growth stocks have been in favour and have outperformed value for a significant period of time but especially in the past two years.

However, in Q1 2021, value stocks came back with a bang outperforming growth by more than 9 percentage points. Value stocks are classified as companies that are currently trading below what they are really worth and will thus provide a superior return. Likewise, we observed that small cap companies have outperformed the index meaningfully. While it’s hard to tell if the factor rotation trends will persist as it’s almost impossible to time these factor rotations, but historical empirical data points to the fact that these factors will contribute to long term.

The value & small cap factors come roaring back

Source: Bloomberg Barclays, FTSE, MSCI, Refinitiv Datastream, J.P. Morgan Asset Management.

For the CPF-OA Endowus Core Advised Portfolios, which do not have factor tilts and are more broadly passive in asset allocation, the returns have been largely in line with and tracking the global benchmark performance. The equities portfolio returned 6.05% for the quarter - well above the 2.5% annual yield of the CPF-OA guaranteed yield and this follows a strong 15.7% achieved last year and 10 year annual returns of 10.55%.

This compares very favourably to both the returns of OA of 2.5% and the benchmark returns which are lower. The compounding cumulative effect is amplified over the long term and it is interesting to note that even the 100% fixed income portfolio generated 3.5% over the 10 years compared to the 2.5% for OA. However, this quarter has seen equities continue to perform well compared to the fixed income market which ended the quarter in negative territory. The diversified and balanced portfolios still generated positive returns.

Q1'2021 Performance of Endowus CPF Core Portfolios

Emerging markets and Asian equities also lagged behind developed markets as part of the overall cyclical recovery. Endowus continues to recommend the globally diversified and strategically passive asset allocation over any kind of tactical allocation that tries to time markets or economic cycles. Historical empirical evidence argues against this and many other digital platforms have underperformed in recent quarters as a result of this.

It is interesting to note that commentators such as Investment Moats have tracked performance of solutions on various digital platforms which have struggled with their tactical allocation and shows how they have underperformed against the passive strategic asset allocation that Endowus espouses.

Q1'2021 Performance of Endowus Cash Management/Defensive Portfolios

The wide range of Cash Smart Portfolio have also generally fared well against traditional fixed income as they are short duration and less sensitive to interest rates rising. The recommended Ultra Defensive Portfolio has also performed better than the 100% Fixed Income Portfolio given the allocation to funds that are more conservative. We should expect that Cash Smart solutions will be susceptible to some short term volatility due to the rising interest rates, but nonetheless, the time to recover from a drawdown will also be faster than traditional fixed income solutions. More details can be found in our Insights article on the Cash Smart Ultra launch and March Review here.

Our clients' concerns in Q1'2021

Fixed Income Markets Witnessed Volatility

We saw disruptions in the fixed income markets in Q1 2021 because the expectations for a strong economic recovery led to expectations that inflation would rise and therefore interest rates would correspondingly increase. As a consequence, we saw the interest rates for long dated government bonds rise which means that bond prices fell. When inflationary expectations rise, longer dated bonds will fall in price more than the shorter dated bonds. This is because the sensitivity to interest rate is higher for long dated bonds.

Short term rates remained relatively well anchored due to the continued low central bank policy rates globally and which has led to a steepening yield curve. While this inflationary outlook is a short term concern, the steepening of the yield curve is not, in and of itself, a necessary negative as it is a sign of the economic recovery and of improved future fixed income yield.

Yield curve steepening is a good sign of recovery and future higher yield

Investors can extend their duration and achieve higher interest rates and the mark to market losses of a rise in interest rates can be overcome with the opportunity to reinvest at higher interest rates achieving long term yields higher than what recent markets were providing. It is also important to remember that even though government bonds, especially for developed markets remain low, there are still opportunities across other geographies especially in Emerging markets, and investment grade credit and high yield bonds to achieve good yields and returns.

Fixed Income Yield and correlation to MSCI World Index

Source: Bloomberg, Bloomberg Barclays, ICE BofA, J.P. Morgan Economic Research, Refinitiv Datastream, J.P. Morgan Asset Management.

Balance of Risks Ahead

While we see a continuation of global recovery with “risk on” sentiments displayed by investors, it is also true that equity market valuations may appear to be high relative to historical averages but we are still at an early stage of market recovery. Earnings are currently depressed and as earnings recover, the valuations will fall as in a normal cyclical recovery. If we use a cyclically adjusted P/E or other measures of extreme valuations, some may be approaching levels, but most are not in extreme bubble territory yet.

Interest rates will remain low until 2024 while inflationary pressures will be transitory. The Fed and global central banks remain committed to keeping short term interest rates low and liquidity abundant. Credit markets will be well supported with improving fundamentals and sectors offering lower sensitivity to rising interest rates will be in focus. The cyclical outlook remains constructive and the balance of risks suggest that portfolio diversification is vital. Historically in low inflation environments, stocks and bonds have exhibited negative correlations. Therefore it will make sense to continue to diversify using both asset classes.

While the business cycle can be a critical determinant of asset performance over the intermediate term, it does not matter in the longer term.  Stocks have consistently performed better earlier in the cycle, whereas bonds tend to outperform during recession. Portfolio returns are expected to even out over the long term (>10 years), regardless of the starting point of the cycle phase. Effectively it pays to remain invested for the long term and not time the market.

Returns even out over the long term

Is the 60-40 balanced portfolio dead?

Popularised by the late founder of Vanguard, Jack Bogle, and based on the Modern Portfolio Theory of Harry Markowitz, who espoused the benefits of diversification, for decades the 60-40 balanced portfolio was deemed to be the best way to manage a diversified portfolio. It’s beauty was in its simplicity. It’s simple and more importantly, it works.

Many have touted the demise of the 60-40 or even called its death. But like many things in finance, predictions about the future are more often wrong than right. After a brief period of struggle, the 60-40 portfolio came roaring back last year generating double digit returns.

Now the pundits are back as rising expectations of an economic recovery and concerns about rising inflationary pressure has led to a rise in yield and a steepening of the yield curve. This has led to some short term negative returns in fixed income.

Correlation between stocks and bonds remain negative

The doomsday forecasters are back to make up for their wrong predictions of the past and they are thinking it’s a great time to correct their wrong by calling again for the death in the 60-40.  Much of this predictions of doom have been predicated on the concern that “this cannot continue” - both the long bull market run in equities (with high valuations making future return expectations lower) and fixed income (where we are approaching levels of interest rates which will not allow us to achieve good enough yield).  The argument normally follows that for these reasons, both equities and fixed income will underperform historical returns and therefore we should diversify away from these assets, and include gold, commodities, real estate or add new alternative investments such as hedge funds, private equity or venture capital funds. Some have even talked about collectibles, timber, wine, and cryptocurrency as possible candidates to “improve” the 60-40.

10 year government bond returns during equity market shocks

Source: J.P. Morgan Asset Management, Refinitiv Datastream. MSCI World Index in local currency terms. Tech bubble: 24 Mar 2000 to 21 Sep 2001, Global financial crisis: 13 Jul 2007 to 9 Mar 2009, Eurozone sovereign debt crisis: 18 Feb 2011 to 3 Oct 2011, Covid-19 : 19 Feb 2020 to 23 Mar 2020

But the key is the correlation between stocks and bonds and whether they remain low or negative. In times of crisis, it is this negative correlation that drives the benefits of diversification and the purpose of the 60-40 portfolio. As highlighted during the 2020 March Covid-19 induced market volatility, the 60-40 portfolio performed admirably, holdings its ground well.

Endowus Cash/SRS 60-40 portfolio - Historical performance

Discipline and process should overcome herd instincts

The Endowus 60-40 portfolio for Cash/SRS and also CPF has shown long term actual results that are still admirable and continued to perform for our investors last year and into this year. We still believe there are tremendous benefits to having a balanced, diversified portfolio if it is a suitable level of risk for the investor.

So the age-old wisdom of not putting your eggs in one basket holds true and we tend to agree that the 60-40 portfolio will continue to work well for individual investors. Unless you are an institutional investor or a private wealth client, adding less liquid investments such as hedge funds and private equity funds to your asset allocation to improve risk adjusted returns will not be the go-to solution.  A good word of advice would be to avoid herd instincts and stay true to your investment philosophy. An evidence-based and disciplined process of investing towards your life goals and being strategic and passive in your asset allocation is not only time-tested but is something you can continue to implement with ease and peace-of-mind. Investors should avoid following the herd into the latest fad in their investment journey.  Endowus is here to help you stay on track and find the most suitable portfolio for your needs and your financial goals