- Nobody knows what will happen next in the economy. But if you have strong convictions about what could happen, that may influence your investment choices in the near term.
- Long-term investors don't need to, and probably shouldn't, bet on the next move in this unprecedented global economic situation.
- Instead, diversifying among investments that could do well in a couple of potential scenarios may make sense and could improve returns.
- My favorite pairs today are large-cap growth paired with small-cap value and the health care sector paired with financials.
The number one question debated at most Wall Street firms right now is: How long is the post-COVID economic boom going to last? The answer is key for a lot of investors: The way you see this playing out could influence some investment choices in the near term.
If you believe that the current post-COVID spike in economic activity is leading into a self-sustaining, multi-year period of above-average GDP growth, then you may also be in the camp of investors who believe that:
About the expert
Dr. Claus te Wildt is a senior vice president in capital markets strategy at Fidelity Institutional. He is responsible for formulating and communicating Fidelity's capital market view to Fidelity Institutional's clients.
- The pick-up in inflation is going to stick for awhile.
- Interest rates are going to rise.
- You should invest in areas of the equity market that have historically benefited from strong economic growth such as value stocks, small caps, and sectors such as industrials and financials.
If, on the other hand, you believe that the current boom is going to fizzle out as soon as the fiscal stimulus fades into the past and that because of our aging demographics we are destined to see more modest growth rates, then you may also believe that:
- The spike in inflation is transitory.
- Interest rates might rise but only moderately.
- You should invest in areas of the stock market that can deliver earnings growth without a lot of help from the economy such as large caps, value stocks, technology, and health care.
I have come to the very unsatisfactory conclusion that the answer to this question is "nobody knows." And the reason for this is that we are clearly in unprecedented territory. When did we ever have a global pandemic, with fast but globally different vaccine rollout/acceptance rates, massive fiscal and monetary stimulus, and aging demographics at the same time? I can't recall any historical comparisons and without those it is hard to figure this out. And by the way, this is common across the industry. Just look at the equity market's change in leadership during the second quarter (see Growth vs. value).
The green line represents growth stocks (a proxy for transitory above-average growth) and the blue line indicates the performance of value stocks (a proxy for durable growth). You can see that the style outperforming changed 3 times in the quarter! It seems that equity market investors changed their minds multiple times based on the latest data release.
What should someone do now?
Let's start with what you don't want to do. You don't want to do what the equity market did in Q2: chasing the latest news and risk getting whipsawed multiple times. Following such a strategy usually leads into buying high and selling low. (Believe me, I tried, it doesn't work.)
So what should you do? I would probably start with the tried-and-true notion that in times when you don't know or are very uncertain, you should never take on a lot of risks. You should make sure that you are well diversified. In this specific case, I think it means that your equity exposure should be broadly diversified with asset classes that provide exposure to both economic outcomes mentioned earlier. These asset classes would be growth and value, large and small caps and economically sensitive and non-sensitive sectors. Having many types of investments in your portfolio can smooth out returns over time and potentially reduce the magnitude of swings in value. But it's important to remember that diversification and asset allocation do not ensure a profit or guarantee against loss.
When I employ such a strategy, I like to think about investments in pairs that I view together as one investment. The idea is that together you expect a decent return but with a much smoother ride. On the chart below that would be the orange line as it represents the performance of an equal investment in growth and value stocks at the beginning of the second quarter.
Think about that experience compared to an individual investment in either growth or value. On the positive side, you would have saved yourself a lot of stress by investing in both growth and value. However, some of you might also think that your return would have been a lot better investing in just growth stocks. That is true, but only with perfect hindsight.
I think a diversified approach is especially important in times like this where we are in unprecedented territory and the outcome is very uncertain. Right now my favorite pairs are large-cap growth paired with small-cap value and the health care sector paired with financials. Both of these pairs feature asset classes that are cheap compared to the rest of their peers and provide exposure to different economic outcomes. I think together they have the potential to beat the orange line in the chart above as well over the long-term—but at the very least should reduce volatility.
Of course, if you already have an investment plan designed to weather most economic environments, it can make sense to stick with your plan. If you want help navigating the market now and in the future, consider working with a financial professional to build a plan that could work for you.