Bull market or pockets of bubble?

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Q1 2021 Putnam Dynamic Asset Allocation Funds Q&A

• We are bullish on equities in the second half of 2021 until the Fed signals a tapering of its bond-buying program.
• The prospects of inflation and rising interest rates will test fixed-income markets.
• President Biden’s $1.9 trillion stimulus package and Covid-19 vaccinations will likely lift the economy.

How were market conditions in the first quarter?

Global financial markets ended the period mixed. Key equity market indices edged higher, driven by progress on Covid-19 vaccinations, stimulus packages, loose monetary policy and signs of economic recovery. In February and March, markets experienced bouts of volatility amid a sell-off in technology stocks, a trading frenzy in small and struggling companies, and inflation fears. The S&P 500 index, a broad measure of U.S. stocks, rose 6.17% for the quarter after hitting records in recent months. International stocks, as measured by the MSCI EAFE index (ND), climbed 3.48%.

The U.S. economic recovery is expected to support a stronger global comeback. President Biden’s $1.9 trillion pandemic relief package has added tailwinds to the U.S. economy, boosted by vaccine rollouts. Stimulus-fueled growth and inflation expectations have driven yields on all but very short-term government debt higher during the quarter. Many investors are betting that inflationary pressures will eventually lead the Federal Reserve to raise short-term interest rates. As a result, rate-sensitive, fixed-income assets ended the period lower.

Yields on the 10-year U.S. Treasury note began the quarter at 0.93% and moved higher to end at 1.73%. Global bond yields, including high-yield and investment grade corporate debt, also trended slightly higher due to rising inflation concerns. Global bonds, as measured by the FTSE World Government Bond Index, fell 5.68%. The Bloomberg Barclays U.S. Aggregate Bond Index declined 3.37% for the period. U.S. high-yield bonds experienced slight strength during the quarter.

How did the funds perform?

The three Dynamic Asset Allocation Funds had mixed results during the quarter. The Conservative Fund, with its more fixed-income-centric investments, fell 0.11%. The more equity-centric Balanced Fund and Growth Fund advanced 3.03% and 4.71 %, respectively. All three funds outperformed their custom benchmarks for the quarter.

What strategies affected performance?

Overall, our asset allocation decisions benefited the portfolios. Given the potential for a full reopening of the economy, we made a few changes to our allocation mix during the period. The portfolios began the period slightly overweight to equity risk relative to the custom blended benchmarks. Not long after, we increased our overweight position, which benefited the portfolios, as stocks soared to new highs with more stimulus and Covid-19 vaccine progress. We decreased our position to modestly overweight toward the end of the period, as it was an opportunistic time to take some profits.

In fixed income, we stayed neutral to rate risk throughout the duration of the period, which did not impact results. The portfolios were neutral to credit risk for the first half of the quarter, before we shifted to modestly overweight. This decision had a negligible effect on performance. An out-of-benchmark, long position to commodity risk, implemented in the beginning of the period, aided performance.

Our active implementation decisions slightly benefited results. Our quantitative U.S. large-cap equity strategy experienced strength, while our quantitative international equity strategy was slightly additive. Selection within opportunistic fixed income enhanced performance to a modest extent. These gains were partially offset by selection weakness from our fundamental U.S. large-cap growth strategy. The DAA Growth Fund experienced a slight loss from emerging-market equity selection.

What is your near-term outlook for the markets?

The global economy continues to recover, although at a slow pace. We remain encouraged by the current tailwinds for financial assets, which include the new U.S. stimulus package, easy monetary conditions, potential infrastructure spending, and ample liquidity. Still, we anticipate volatility in the months ahead as investors weigh the continued rollout of vaccines and the pace of reopening, with its implications for inflation and higher interest rates.

Given the current environment, we are bullish on equities in the second half of 2021 until the Fed is close to signaling a taper of their asset purchase program. The combination of pent-up demand and the Federal Reserve’s easy monetary policy makes a compelling case for equities, we believe. In fixed income, our outlook on credit is modestly bullish. Banks have begun easing credit conditions for large corporate commercial and industrial loans, and average total leverage for new high-yield issues is back to the low levels seen in 2013. Our outlook on rate-sensitive fixed income is neutral, as we believe the distribution of potential outcomes is now roughly in line with long-term expectations. Fed officials have pledged to keep interest rates low until there is significant progress toward their inflation and employment goals for the U.S. economy.

Against this backdrop, we continue to have conviction in our investment strategies based on their strong long-term results. As for asset allocation, we will continue to take a tactical approach, adjusting exposure across various markets as conditions warrant. We will continue to monitor equity and fixed-income markets and add securities when we see attractive valuation levels.