Markets look to Fed, Covid-19 outbreaks for signals

Q4 2021 Putnam Dynamic Asset Allocation Funds Q&A

  • The Fed has set the stage for higher interest rates and shifted to end its asset-buying program earlier.
  • Our outlook on equities is neutral given a move past peak earnings growth and rising interest rates.
  • We anticipate more volatility due to risks from continued pandemic supply-side disruptions, central bank policy, and inflation.

How were market conditions in the fourth quarter?

Global financial markets had mixed results during the three-month period. Stocks were buoyed by a recovering economy, the lifting of mobility restrictions in many countries, and fiscal stimulus. However, risks including higher inflation, rising interest rates, China’s weaker economy, and Covid-19 variants percolated through the markets. For the fourth quarter, the S&P 500 Index — a broad measure of U.S. stock performance — gained 11.03%. The MSCI World Index [ND], a broad measure of equity securities from developed countries, rose 7.82%.

In mid-December, the Federal Reserve pivoted toward tighter policy with plans to end its bond-buying stimulus program in March 2022, paving the way for higher interest rates. Most Fed officials expect to raise interest rates three times in 2022. Other global central banks are also scaling back stimulus measures. The European Central Bank said it would slow the pace of asset purchases under its Pandemic Emergency Purchase Program in the first quarter, bringing the program to an end in March. The rate-sensitive Bloomberg U.S. Aggregate Bond Index, a measure of investment-grade [IG] fixed income securities, rose 0.01% for the quarter.

At the end of November and into December, concerns about the Omicron variant of Covid-19 caused increased market volatility. The U.S. Treasury bond yield curve has flattened. The Fed’s hawkish pivot has pushed up rate-sensitive short-dated bond yields, while the long end of the curve fell due to concerns about the economic impact of rising Covid-19 infections. The yield on the benchmark 10-year Treasury note fell to 1.52% at the end of December, after rising to 1.67% in late November. The yield on the 2-year note rose to end the period at 0.73%.

How did the funds perform?

The three Dynamic Asset Allocation Funds finished positive for the quarter. The Conservative Fund, with its more fixed income-centric investments, rose 1.63%. The more equity-centric Balanced Fund and Growth Fund gained 4.14% and 5.36%, respectively. All three funds trailed their custom benchmarks for the quarter.

What strategies affected performance?

Overall, our asset allocation decisions did not significantly impact performance. The portfolios were slightly under-weight interest-rate risk relative to the custom benchmarks for the entirety of the quarter, resulting in a de minimis effect on results. The portfolios were neutral equity risk and credit risk throughout the period.

Overall, our active implementation decisions detracted from performance. Our fundamental U.S. large-cap growth and international developed equity strategies finished negative. Strategic global macroeconomic trades in fixed income and active currency also weighed on results. Our quantitative international developed and U.S. small-cap core equity strategies were slightly additive. In quantitative strategies, our team analyzes stock market history to identify characteristics of stocks [factors] that have excess risk-adjusted returns. During the quarter, our valuation factors helped results.

What is your near-term outlook for the markets?

In 2021, the global economy continued to recover from the pandemic-induced downturn, driven by substantial monetary and fiscal policy support, pent-up consumer demand, and Covid-19 vaccine progress. Economic data improved and stocks soared to record highs, but volatility crept into markets due to uncertainties surrounding inflation and supply chain issues, central bank policy, and Covid-19 variants. Entering 2022, these uncertainties are still present, and we believe the levels of volatility and sentiment currently priced into markets do not adequately account for them. Thus, we are maintaining our tactically neutral posture.

Given the current backdrop, our outlook on equities is neutral. This view is supported by a move past peak earnings growth, narrowing market breadth, and the expectation for higher interest rates. While we maintain a positive disposition toward equities, we feel risks have become more balanced.

In fixed income, our outlook on credit is slightly bullish. High-yield bond index fundamentals have moved back to reasonable levels, and thus we expect that corporate and structured credit will continue to attract capital in a yield-starved environment. Our outlook on rate-sensitive fixed income is slightly bearish. Real yields are still exceptionally low, and we expect that U.S. monetary policy is likely to tighten from this point on. Fed officials are anticipating three rate hikes in 2022.

Our view on commodities is neutral. OPEC+ is focused on increasing supply as the impact on demand from the Omicron variant is expected to be less severe than originally anticipated. Against this backdrop, we continue to have conviction in our investment strategies.