It may sound counterintuitive, but now is the time for advisors to talk with clients about globalizing their portfolios by investing in Europe and Asian markets, as well as expanding allocations in alternatives and active management.
“For U.S. investors, we’ve kind of had this nirvana period of free lunch in recent years,” said Lisa Shalett, head of investment and portfolio strategies for Morgan Stanley Wealth Management. But that is set to change, and investors need to prepare.
Typically stocks and bonds are negatively correlated, but because of quantitative easing, they were positively correlated, compounding investors’ returns during the bull market following the financial crisis. But as policy begins to normalize and the Federal Reserve looks to raise interest rates marginally, that balanced stock and bond portfolio that delivered double-digit returns will instead return 4 to 6 percent over the next five to seven years, Shalett predicts.
From an investment standpoint, clients should have generally have some global exposure, but the firm is advising clients to increase their portfolios in the European and Japanese markets, said Mike Wilson, chief investment officer and head of research for Morgan Stanley Wealth Management. “International, developed markets are going to continue do better than U.S. markets on a relative basis,” he added, noting that Europe is earlier in its recovery cycle and that is when investors should want to own risk assets.
Japan is an interesting opportunity because it not only has the cyclical forces that Europe does, but it also is undergoing the so-called “Abenomics” economic policies around fiscal stimulus, monetary easing and structural corporate reforms. That third leg of the stool—the corporate governance and change at the mirco-level—is still underappreciated, Wilson said.
“Japan looks a lot like the U.S. companies in the 1980s where there’s a lot of low-hanging fruit where they can generate earnings growth even with low economic growth because they’ve undermanaged their companies for so long. They’re the worst managed companies in the world. But that’s changing slowly,” Wilson said.
In addition to seeking out opportunities in global developed markets, Shalett says now is the time for advisors and investors to re-think how they handle volatility. Historically, one way to manage this is through bonds, and while they will continue to play a role, there is also the ongoing risk of capital loss.
Instead, Morgan Stanley has been advising investors to give alternative products a second chance. Over the last six years, because of the depressed volatility in the markets, many alternatives have disappointed investors. They need volatility to demonstrate their value proposition, but that is very much in question right now.
“One of the challenges is convincing clients that just at the moment when it looks like this asset class has lost ethicacy, is exactly the time you need it. So we’re emphasizing using various alternative strategies to help us manage risk,” Shalett said, noting those strategies include hedging, equity-long short, global macro and event-driven strategies.
And while alternatives on a whole have underperformed, private equity has been booming. But Shalett said the asset class is maturing, predicting we’re in the sixth or seventh inning of the cycle for private equity. So while that’s an area of ongoing opportunity, it’s not where the firm is focusing its efforts.
Morgan Stanley is also encouraging investors to get behind active management again. In recent years, passive management has outperformed active substantially, but Shalett predicts this will likely change in the near future.
“Yet again, this is the exact point where people have almost given up on active that it’s highly likely that active management is going to work and add value,” she said. During the latest selloff in August, Shalett said that active managers outperformed passive managers in a “really big way.”
“A lot of our advice is about rebalancing this bias our clients have taken toward passive and come back to active because we think active management can also outperform.”