Morningstar - Q2 2022 - 9

EXHIBIT 1
denting net savings and potentially affecting
investors' financial goals. At a portfolio level, this
also might be an issue, with defensive assets
earning less than the inflation rate. This results in
a reduction in real purchasing power, which can
also disrupt an investor's goals.
There are no easy answers to this challenge in an
environment such as today's, but one approach is
to focus on real outcomes after inflation. At a
portfolio level, this means holding assets that may
protect against a spike in inflation.
Adding Value in a Downturn
Putting aside the challenges of erosive inflation,
we believe investors can benefit by buying into
negative sentiment, especially if they are willing to
take a long-term view. This point should not be
underestimated, given that most economic
recessions prove temporary and losses may be
recoverable in an investor's time frame.
By taking such an approach, we can be anticyclical,
or contrarian, when others aren't. Furthermore,
weathering a recession will probably be
easier if the motive is to be fearful when others
are greedy and greedy when others are fearful, to
paraphrase Warren Buffett. This tends to
be possible because negative sentiment is often
exacerbated in a crisis. For evidence, EXHIBIT 1
shows the difference between changes in
sentiment and fundamentals during the global
financial crisis of 2007 to 2009.
The second consideration in a multi-asset context
is to diversify the risk drivers. This goes beyond
questions such as whether U.S. companies
can maintain high profits or how long inflation may
rise. We may seek to understand the answers
to these questions (and many more) in the context
of valuations, but we should also acknowledge
the role of uncertainty.
A Deeper Understanding of Diversification
Diversification is an important tool to manage
uncertainty; however, it must go beyond
putting your eggs in multiple baskets. To us, it is
about understanding the underlying risks to
assets-whether those are economic or
market factors-not just volatility or correlations,
as these can change quickly and drastically.
Sentiment Versus Fundamentals During the financial crisis of 2007 to 2009, returns
fell far more (as a function of negative sentiment) than corporate fundamentals.
Implied Growth
Expectations Per Year
4%
1
2
3
-1
01/2007
10/2007
07/2008
03/2009
Note: Total return is the return of the S&P 500 index. Fundamental return is the return of total payout yield plus the growth of total payouts. Growth
expectations are the market's implied growth rate assuming a constant cost of equity.
Source: Morningstar Investment Management calculation. Data from January 2007 to March 2009.
-58 -60
Total Return
Growth Expectations
Fundamental Return
Cumulative
Return
20%
-17
-40
-20
For example, corporate bonds and equity
markets can behave very differently, yet both are
susceptible to economic shocks. (Damage to
corporate earnings could cause equity values to
fall and bond spreads to widen.) All else being
equal, this offers less diversification than
holding equities and an unrelated asset, such as
inflation-linked bonds or nominal government
bonds. The message to investors is to diversify
against fundamental risks and be very intentional
about how they are diversifying if they want
to reduce the impact of an economic recession.
Long-Term Mindset a Winning Approach
The current crisis has been having an impact on
valuations of asset classes-obviously in
Russia, but also beyond the Russian markets. Most
notably, the sovereign bond yields of other Central
and Eastern European countries have risen,
and their currencies have fallen. Corporate bonds
have also been hampered, with credit spreads
widening for high-yield and investment-grade debt,
not just in Europe but also in the U.S. market.
In equities, there have been clear winners and
losers, with global energy firms rallying and
stock markets more closely tied to Russia, such as
Germany's, suffering large losses. These are
investment areas that require researching to see
whether they might provide robust risk-adjusted
returns in the future.
We don't necessarily buy that one should
engage in widespread selling based on fears of an
economic recession. Naturally, we want to be
diversified to reduce the impact of any downturn,
but by taking a long-term view, we should
only really care about a permanent impairment of
earnings and the price paid for those assets.
Moreover, if the economic cycle dents corporate
profits in the near term, negative sentiment
could lead to undervalued stocks and allow
investors to ride out the cycle until it reverts. This
is one of many areas where we can add
value, by maintaining a long-term view when
others won't. K
Scott Dixon is head of content strategy at Morningstar
Investment Management.
Ricky Williamson is head of U.S. outcome-based strategies
at Morningstar Investment Management.
Mark Preskett is a senior portfolio manager at Morningstar
Investment Management.
Dan Kemp is global chief investment officer at Morningstar
Investment Management. He is a member of the editorial
board of Morningstar magazine.
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