The global economy has recovered from the pandemic sooner than most expected, with diversified investors benefiting from financial markets. But with growth now expected to be at its peak, U.S. asset managers, in particular, must now grapple with new concerns surrounding interest rates, inflation, and valuations.
According to Nuveen’s mid-year outlook released Monday, “a booming economy brings with it new opportunities — and risks.” While asset growth improved from 2020, yields are still “frustratingly” low, which means returns may be fewer and far between in the second half of 2021. Moving into the second half of the year, the asset manager recommended clients consider differentiating between short- and long-term inflation risks and diversifying income and asset classes.
“Both the level of output and its first derivative (growth) remain quite strong. It’s the second derivative — the change in the rate of growth — that has started to fall, presenting a challenge for investors and policymakers alike (not to mention those charged with making economic forecasts),” the report stated.
“When we say ‘frustratingly low,’ it’s from the perspective of an institution,” Brian Nick, co-author of the report and chief investment strategist at Nuveen, told Institutional Investor. Nick said that means investors likely need to take different kinds of risks — and more risk overall — to get even close to the same amount of return they've earned in other market environments.
Out of the ‘Dark Tunnel’ and Into the ‘Bright Light’
At this point in the pandemic recovery, authors of the report believe the world is “at or approaching peak economic and earnings growth.” For institutional investors, this peak will require strategic decisions in the second half of the year — the deceleration period.
“Coming into the year, we had a pretty upbeat assessment of how things would go, and I think things have gone a bit better than we expected,” Nick said. “We got through what we call ‘the dark tunnel’ and we’re now in the ‘bright light’ phase.”
In this newfound brightness, the Federal Reserve’s reaction to inflation has been an area of concern for investors though most believed the issue was transitory. The authors expect the Fed and other central banks to taper their quantitative earnings programs at the beginning of 2022.
“Any tapering announcement would likely bring a lurch higher in real interest rates,” the report said. “But history tells us that a variety of asset classes can perform well over all but the very shortest time horizons in this environment including, significantly, the equity market.”
Nuveen doesn't expect inflation to rise to a level that would shift central bank policies or near-term growth.
“It looks to me that inflation has peaked in the U.S.,” said Nick.
The report also advised investors continue casting a wider net for income, meaning investors need to expand beyond traditional fixed income classes as yields remain low. The authors recommended “exploring different areas of the fixed income landscape, dividend-paying equities and alternatives such as real estate, real assets and private credit.”
“You probably want to, as a rule, invest more in higher yielding parts of the fixed income market, where you get a nice cushion above what treasuries are paying, because the return on U.S. treasuries could be basically entirely swamped by inflation on an ongoing basis,” Nick said.
The report also highlighted Environmental, Social, and Governance investing as an increasingly attractive opportunity, with no signs of slowing down. “The pandemic exhibited how strong corporate governance, business continuity, human capital and supply chain management are critical to driving performance across asset classes. We do not see that changing.” Nuveen viewed ESG investing not as a strategy that excludes certain companies or assets, but as an opportunity to “enhance our return generation and risk management processes.”
Nuveen sees the importance of ESG growing in both public and private real assets. “In public investments, we believe ESG factors are an important marker of quality. Since investors are increasingly seeking out ESG investments, companies with favorable ESG profiles tend to trade at a higher premium compared to those with unfavorable profiles.”
The report also encouraged investors to dip into a wide array of asset classes in the second half of the year. Nuveen proposed prioritizing credit risks over duration risks in fixed income and to dive into high-grade and high-yield municipal bonds, niche real estate, and real assets like farmland, renewables, and infrastructure.
Nick also suggested diversifying assets by geography: “The second half of the year might be a better time to be in these non-U.S. assets, whether it's credit or equities because there just hasn't been the same degree of reopening progress and outperformance in those markets.”