Why macro matters: How Morgan Stanley is positioned for 2022 and 2023

Value should beat Growth, stocks will continue to outperform, and balanced portfolios will be as efficient as ever over at least the next couple of years. So says Morgan Stanley Wealth Management’s asset allocation strategist Alexandre Ventelon.

During the following Q&A, he makes a broad comment about how the very strong intervention of central banks since the GFC, ratcheted up further still since the pandemic, has changed the interplay between stocks and bonds.

“I understand many people are concerned, but the fact we’re now in the process of tapering QE in the US and around the world emphasises that, in the long run, macro matters," says Ventelon.
"And if the stimulus is being withdrawn, it’s because the economic fundamentals are sound.”

Ventelon’s investment career has spanned multiple continents including Europe (France and Luxembourg); and Asia (the sovereign republic of Singapore); before he landed in Australia a decade ago. Up-close experience of multiple regions is a big bonus when working on the multi-asset team of an internationally renowned brand like Morgan Stanley.

Before joining Morgan Stanley in 2017, Ventelon spent a few years helping build portfolios for Australia’s largest superannuation fund, Australian Super. This emphasised and strengthened his skills in portfolio efficiency. Putting these to work in the highly diversified, global business of Morgan Stanley’s multi-asset team presented Ventelon with an enticing challenge.

From this starting point, our recent interview delved into Morgan Stanley Wealth Management’s investment process and, perhaps most importantly, its outlook for 2022 and 2023.

Below you will read Ventelon's views on the following topics:

• Why he believes the equities bull market has further to run.
• Why the Value side of Morgan Stanley’s investment barbell outweighs the Growth side.
• The sectors his team is backing most strongly.
• Where to invest when “what’s good is expensive,” including in the sub- and investment-grade parts of credit markets.

He also outlined the two biggest risks on the horizon from next year, outside of COVID, and how Morgan Stanley is positioned for them.

Edited transcript

Glenn Freeman: How did your experience at Australian Super inform your approach to working in the wealth management business at Morgan Stanley?

Alexandre Ventelon: It helped bring what I would call “institutional rigour and flair” to our multi-asset models. Super funds have done well in the way they’ve accepted more Growth assets into a single portfolio, often through the use of Alternatives and private assets, for example. Super funds have a genuine long-term horizon but also benefit from a positive cash flow profile. That gives them more room for risk-taking. That's really helped us frame our portfolio construction process.

With regards to building our risk profile, this includes taking a step back and thinking:

• Who are the portfolios designed for?
• What are the risk-return objectives?
• What is investor risk tolerance?

We then try to build an optimal allocation that will manage the two sides of risk. That dual nature of risk One isn’t discussed enough in relation to investing and financial markets.

One is, of course, minimising the effect of large slowdowns because they will diminish the capital value of the portfolio

The other major risk is the opportunity cost of missing out on large market rallies. You can leave a lot of money on the table if you don't have an appropriate risk profile, or if your risk profile is not well aligned with your objective.

The success of super funds has really gone a long way in terms of investor education, including about Alternatives and private markets. And given they offer attractive risk-adjusted return, often in exchange for lower liquidity, they still help to build more efficient portfolios.

Being able to bring more Alts and private market exposure into our portfolios was very attractive for me. And I wanted to make more efficient portfolios, achieving similar returns, if not higher, with less pronounced effects from drawdowns and with more diversification.

Four or five years ago when I started that’s not something we did a lot of at Morgan Stanley, though at the time there were few appealing offerings and not many appropriate vehicles available in the Australian market.

But since then, the quality and the availability of the products in Australia has gone a long way.

Freeman: When building investment portfolios, is the 60/40 split between equities and bonds still relevant?

Ventelon: The end of the 60/40 portfolio has been called for years, probably around 15 or more years since I started managing multi-asset portfolios. And yes, there is increasing competition for the traditional 60/40 model.

What’s the best alternative to 60/40? It’s probably the endowment model, which has been made popular by Yale and Harvard in the US. Some of their findings are used in Australia by the Future Fund. It's a very efficient way of investing. But it really necessitates a few things:

• a long term horizon,
• being very comfortable with illiquidity
• the ability to partner with the right financial institutions to source top-tier alternative managers.
• You need scale.

Institutions such as not-for-profit organisations or family offices can find that a suitable model for them, but it’s not really accessible for retail investors.

I’d also emphasise that fourth point: you need size to be invested via the endowment model because often the minimum investment? size is quite high, which create several hurdles.

But my point here is that, despite all the criticism, the 60/40 portfolio has done the job and it's done it well. If we just look at our more conventional solution, our “Core Balanced” model portfolio has returned 8.9% annualised since 2012.

But beyond this absolute number, it’s interesting to compare that to the peer group, as defined by Morningstar. Most will have Alternatives and innovative ways of investing. This model portfolio doesn’t, but it's still beating the average comparable fund in Australia by 2.1% since inception.

Freeman: So, why do we keep hearing that 60/40 is broken?

Ventelon: I think it's the secular fall in bond yields that create a much lower base in terms of income at the portfolio level. Because, dividend yields on the 60% equity allocation – tend to be quite stable over time. But the other 40% has been falling dramatically. If you use bonds in multi-asset portfolios, it’s for two reasons: income and diversification.

Investors realise they’re no longer getting the levels of income from bonds they did traditionally. And secondly, diversification benefits far milder when bond yields are lower and duration is higher. And when bond yields rise again, you also get hurt on the way back up.

But again, I believe that we tend to underestimate how much of the portfolio outcome in a 60/40 portfolio is driven by the equity bucket. By having an appropriate range of equity investments you can still deliver a very decent outcome in various types of environments. Bonds have done the job most of the time, in terms of portfolio protection, with only a few examples of both bonds and equities selling off simultaneously.

When there has been a recession risk or a major market scare around economic growth, which is very often the key risk for us as investors, bond yields went down and bonds in Value went up. So, the diversification benefits were still there. On a net basis, things are still doing what they're supposed to do, it's just that we are getting a little less income.

Freeman: How has the change in correlation affected the way investors think about fixed income?

Ventelon:

It's a very good question. The very strong intervention from central banks in the last 15 years and in the post-GFC period in general has really changed the deal, in shifting the correlation between equities and bonds. For around a decade, bonds and equities have rallied almost in tandem.

Yes, it has broken the correlation. But if you look at market drawdowns especially, fuelled by growth scares, most of these events have seen equities and bonds going in different directions. That's what I call doing the job.

It’s completely rational that investors are concerned because we’re right now in the process of tapering QE in the US and other markets around the world. And this QE has done such a great job at taking bond yields down, which will have some negative implications for bonds in terms of the value of the bonds and in terms of equity valuations as well.

But again, I like to take it back to the point that in the long run macro matters. And if these stimulus measures are being withdrawn, it's because the economic fundamentals are sound. That generally translates into relatively strong equity earnings. So we should be in an environment where equities are going up and probably bonds are going down, which is a natural environment for the market.

Freeman: How does that square with the argument that we were hearing, especially pre COVID, that equities are late cycle?

Ventelon: That’s just the nature of the market. You will always find bears among the bulls. We have very much a cycle driven approach at Morgan Stanley, and our key message, in this regard, is that we are mid-cycle, not late-cycle. The late-cycle is when you have totally squeezed unemployment and when the yield curve is inverted.

Until a couple of months ago, the yield curve was steepening, which we expect to resume next year. And if you look at unemployment especially, if you look under the hood at what we call variables such as underemployment, there is still plenty of work to be done before we squeeze that entirely. That's the first point.

We've jumped from the repair phase of the cycle, which is from phase one to the expansion phase, which is phase three. We have skipped the recovery phase which is phase two, and that's quite unique. That is very much due to the V-shaped recovery. This is something we called about 18 months ago when we thought this recovery would be extremely sharp and we would close the gap on growth remarkably quick. That's exactly what happened.

Expansion is when we have above trend and rising macro variables. That's a pretty good macro backdrop. And traditionally, it's also a phase that coincides with above-average returns on risk assets, especially equities.

It's a phase of the cycle that tends to last several years. So we are not expecting the end of the cycle next year.

Concerns that valuations look a bit more like late-cycle - and it’s true that this will be a headwind. The key headwind for us going into this expansion phase is that several asset classes have a bit run ahead of the market in that sense. There will no longer be such huge potential for multiple expansions. And most of the growth in terms of equity prices has to come out of the earning side of things because we will not get a lot of support from valuations.

Freeman: What's the biggest threat to markets, if not COVID?

Ventelon: The number one risk we see is a slower recovery in China – and that applies also to the broader EM Asia region.

China is dealing with the restructuring of its economy. And also, the strong US dollar is a headwind for financial conditions in EM.

We’re monitoring this into 2022. But we see this as relatively low risk. We’re confident that we’re are going into a relatively strong year in terms of economic activity; EMs will get their share.

We also expect a weakening US dollar in the second half of the year, which is going to provide a bit of a relief to emerging markets as well in terms of financial conditions. And China is going to stimulate its economy as well. It can’t stimulate as much as in the previous cycles but will still be quite stimulatory, in our view.

Another big thing we’re watching for is central bank policy mistakes. For example, what if central banks tighten monetary conditions at a time where we are losing momentum in economic activity? In 2013, and 2014, CBs became more hawkish while economic conditions were slowing.

That's not too far from another key risk that we see, the potential for inflation to overshoot. That would force the hand of central banks, and you can already hear it in the way their tone has shifted.

For example, the Fed has said it regards inflation pressures are temporary. But increasingly, in the last statements and public speeches, it has conceded some factors are pointing toward some more structural factors.

Our view is that a lot of the temporary factors in the current inflation will normalise. But if that doesn’t occur, central banks may intervene? much faster. And that could create an environment where bond yields sell-off which would clearly put a lot of pressure on equity evaluations – that’s a scenario where we would expect to see a re-rating of stocks.

Freeman: Which countries and sectors are you most bullish on for 2022 and 2023?

Ventelon:

Our view is that markets are in a mid-cycle. That's part of the cycle that is supportive for equities in absolute terms but also in related terms.

Even though the returns aren't likely to be as good as what they've been in the last 18 months. We still expect equities to beat others as a class, especially bonds and high yields in the next 12 months.

What we are looking for really is assets that will give us a combination of strong fundamentals and decent valuation. It's a very hard one to find because what's good is expensive as often. And right now, most of the main asset classes are expensive. Credit whether it's investment grade or sub-investment grades expensive. U.S. equities which is the highest quality market in the world is expensive. Australian industrial ex-financials are trading at more than 30 times as well.

Where we find value backed by good fundamentals, Europe, and Japan, because they have more cyclical exposure. They will get a kick from the reopening, the fiscal stimulus kicking in, and still very stimulatory monetary policy.

And these are also markets that tend to outperform when the global yield curve is steepening, more specifically for Europe.

In terms of style, we aren’t hugely overweight on one side or the other, though we do have a Value preference. This does translate into either playing Value as a direct exposure or via sectors, such as financials.

Domestically, we retain Resources exposure. We have a skew towards energy away from iron ore, we’re looking more at what we call “diversified commodities”. Energy is our preferred commodity, mainly because we see strong support for the oil price.

In terms of other sectors, we still see good quality in Australian Healthcare and in Financials, particularly the non-banks. Valuations are reasonable. You get very good exposure to a strong economic cycle and a strong market cycle. These tend to correlate well with the yield curves steepening, which is what we see for next year.

Specialist advice from Morgan Stanley

Morgan Stanley Australia focuses on providing individuals and institutions with specialist strategic advice and then helping implement these strategies through superior investment execution. 

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