IN AN ENVIRONMENT OF LOWER RETURN EXPECTATIONS AND HIGHER, MORE VOLATILE INFLATION, ACTIVE MANAGEMENT ADDS SIGNIFICANT VALUE, SAYS JONATHAN HUBBARD, MANAGING DIRECTOR OF THE STRATEGY AND INSIGHTS GROUP AT MFS INVESTMENT MANAGEMENT.

Investors should aim to build resilient portfolios, he adds, and it’s important to consider the entire opportunity set and exploit multiple dimensions of diversification when doing so. After all, diversified sources of alpha and risk can be found not only across asset classes and regions, but also across factors, styles and investment approaches.

WHAT IS MFS’S APPROACH WHEN DEVELOPING LONG-TERM CAPITAL MARKET EXPECTATIONS?

There are many ways to put together market expectations—from a macro, top-down approach to complex statistical methodologies. At MFS, we take a building blocks approach, looking at the fundamental underpinnings of return. On the equity side, the primary building blocks are price-to-earnings ratios, profit margins, real sales and dividends, with one macro factor: inflation expectations. On the fixed-income side, we focus on starting yield, credit spread, credit loss expectations, yield curve shape and hedging impact. We look at where we are today relative to our expectations for each of those building blocks over 10 years. Then we roll those up into a single point forecast for each asset class. The most useful way to employ our point forecasts is to compare forward-looking expectations across asset classes and regions, as well as relative to their own history. From there, you can analyze which return drivers are expected to contribute or detract from returns.

WHAT IS MFS’S LONG-TERM OUTLOOK FOR PRIVATE AND PUBLIC CREDIT?

To provide context, 2022 was a painful year of negative returns for both equity and fixed-income investors. Typically, when a balanced portfolio experiences a deep drawdown, one asset class is responsible. This time, it was both. Now, we’ve reset at higher yields and fixed income is again doing what it’s supposed to do—providing income, diversification benefits and downside protection. We’re starting to see more normalized correlations; and the potential for a 5 per cent yield with 4 per cent or 5 per cent volatility in core bonds is appealing when compared to much higher volatility in equities.

Our overall outlook for global fixed income is around a 5 per cent total return. It’s slightly higher than that for private credit, but with the risks of lower liquidity and less transparency. Private credit came into its own following the global financial crisis, when banks were reluctant to lend, investors were looking for yield and private credit managers stepped in to fill the gap. However, private credit hasn’t seen a full credit cycle and how it performs at the cycle’s end is still unknown. We saw disruption in the credit markets in the first two quarters of 2020, but it was accompanied by a pandemic response that included massive central bank-supplied liquidity across every developed country, resulting in short-lived market disruption. That said, it’s unclear how private credit will behave if we have another credit event. Just as fixed income is more appealing than equities on a risk-adjusted basis, public credit looks more attractive than private credit right now, but we believe there can be a place for both in portfolios.

WHICH OF TODAY’S GLOBAL TRENDS ARE LIKELY TO HAVE THE BIGGEST INFLUENCE ON MARKETS OVER THE LONG TERM?

First, we believe we’re going to be in a higher inflation rate environment. That doesn’t mean we’re going to go back to high single-digit inflation numbers, but there will likely be more variability and we’ll see inflation settle into a higher envelope than during the pre-COVID period.

Second, global trade flows and supply chain logistics are changing as countries reposition whom they’re doing business with and how they’re structuring supply chains. A stark example is the recent electric vehicle tariffs levied on China by both the United States and the European Union.

Third, fiscal and monetary policy are likely to be different over the next decade than what we’ve seen in the past. Policymakers have rolled out new tools and approaches, expanding their imagination in terms of what’s possible, and this has shifted the window of acceptable monetary policy actions.

HOW WILL DISRUPTIVE TECHNOLOGY LIKE ARTIFICIAL INTELLIGENCE (AI) PLAY INTO CAPITAL MARKETS?

The jury is still out on that. There’s been a tremendous amount of excitement and success for chip, cloud and infrastructure providers. Corporations have committed a significant amount of capital expenditure learning how to implement these tools, but they still don’t know quite how to best deploy it or how to measure the return on investment. It took corporations about 20 years to efficiently use the Internet, and that was accelerated by the pandemic speeding up adoption of remote work tools. I don’t think it’s going to take 20 years for companies to effectively implement AI, but it could take a lot longer than people are expecting—and it might be harder to determine the return on investment than many think. That said, advancements in technology are moving at an incredible rate and AI will surely impact several pockets of businesses and society.

WHY IS IT IMPORTANT TO TAKE A LONG-TERM PERSPECTIVE ON CAPITAL MARKETS?

It’s critical to recognize both how much noise there is in the market and how many ways there are for investors to absorb that noise. It’s not just through emails, research reports and videos, but through social media and instant messaging platforms. So there’s more noise and media through which to absorb that noise than ever before. This can make focusing on the long term difficult, both consciously and subconsciously.

Also, markets tend to miscalculate multiple dimensions in any given year. Markets can overshoot and undershoot earnings or overall economic activity, for example, but when you take a step back and measure those things over longer periods of time they tend to average out to a more natural level. What we can’t determine in advance is the path to get to that level. However, when you look at the fundamental underpinnings of return, such as the building blocks I mentioned, over longer time periods, it’s much easier to determine where they’ll be in 10 years than in a week, month or year.

The fact is, many of our clients— whether that’s pensions, endowments or individuals with retirement savings— have a 20-year, 30-year, 40-year or infinite time horizon. Yet, when you measure things over a very short timeframe, it can lead to behavioural mistakes fuelled, for example, by well-known behavioural biases, such as loss aversion or recency bias. It’s easier to control these biases when you stay focused on the long term.

HOW CAN ACTIVE MANAGEMENT HELP STEER INVESTORS THROUGH MARKET UPS AND DOWNS?

Alpha generation is going to be increasingly important in the lower total return environment we’re projecting, particularly on the equity side. Disciplined risk management will also be critical. Higher and more variable rates of inflation could exacerbate market swings—for instance, if central banks unexpectedly change course.

In addition, there’s significant concentration risk in the passive market. In August 2024, the S&P 500 Index had 37 per cent of its weight in 10 stocks, and many of those stocks were doing significant business with each other. Just 10 years ago, in 2014, the top 10 stocks only accounted for about 17 per cent of the index. Canadian equity markets have substantial concentration risk, too, because they’re structurally biased towards financial services, energy and materials.

Today’s investors need to determine whether they’re comfortable putting their next incremental dollar into an index with a high level of concentration and holding their current allocation when an index looks so different from when they initially invested. There’s nothing wrong with taking risk as investors. That’s what you should be doing. But you need to make sure risk is intentional—and for many investors, concentration risk through passive investing is an unintentional risk.

Distributed by: MFS Investment Management Canada Limited.

The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice. No forecasts can be guaranteed. Past performance is no guarantee of future results.

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