This article is part of Fortune‘s quarterly investment guide for Q2 2020.
When we catch up with Lori Heinel, she, like most American professionals these days, is working remotely. In Heinel’s case, she’s holed up in western Pennsylvania—a considerable distance from the Boston headquarters of State Street Global Advisors, where she serves as deputy global chief investment officer for one of the world’s largest asset management firms.
“I have family here,” she notes of her new surroundings, which sound like they lend themselves quite well to the new norms of self-isolation and social distancing. “There’s literally nobody around.”
Though the setting may be bucolic, Heinel’s job at State Street, which manages over $3 trillion on behalf on more than 2,500 institutional clients globally, is a bit more high pressure. Working alongside State Street global CIO Richard Lacaille, she helps coordinate the asset manager’s myriad client-facing services—from market research to investment strategy and products—while also focusing on internal governance, oversight, and due diligence.
But in speaking with Heinel for Fortune’s Quarterly Investment Guide, there was really one place to start: the ongoing coronavirus pandemic, its devastating impact on both the financial markets and the overall economy, and where she sees things going from here. As she notes, investors are now dealing with “a different kind of crisis”—one that “doesn’t emanate from any of the traditional things that drive the markets.”
“All of the things we’ve learned to assess as investors, this [situation] throws all of that out of the window,” she says.
This conversation has been edited and condensed for clarity.
The scope of the coronavirus outbreak may have caught investors by surprise—but now that you’ve had time to consider the possibilities, what are your expectations for how this plays out? Are you more optimistic or pessimistic about what’s in store for the markets?
If this thing goes on for months—or, God forbid, years—it’s game-changing. Our working assumption right now is that this is a one-quarter, maybe two-quarter event, where maybe by the early third quarter we get somewhat back to normal. If that’s the case, then we could have pretty sharp, pent-up demand in the second half [of 2020] that should release to the degree where corporations that haven’t seen physical disruptions can ramp up pretty quickly. It’s a terrible situation, but we do believe that it can set us up for a second half that’s pretty reasonable, and a 2021 that could be stronger.
How has State Street responded to the pandemic as far as reallocating and recalibrating its investment strategies on behalf of clients?
First off, we did reduce our overallocation on equities. We have a monthly process where we look at relative valuations and sentiment indicators, and we reduced on equities—but we remain overweight, particularly in the U.S. We do believe that with the pullback in valuations—coupled with strong stimulus measures—there is some opportunity. We focus that [outlook] on large-cap [stocks], not small-cap; we think the headwinds for small-caps are greater, especially with credit concerns.
Mortgage-backed securities have encountered a fair amount of trading stress. But from the standpoint of credit quality and yield—and with the Federal Reserve coming in to make purchases—we think they’re interesting as far as the fixed-income world. We’re more cautious about high-yield [debt] right now. If clients do retain an interest, we encourage them to go active and be more selective.
We’ve also had a position on gold for over a year now. We don’t have a strategic allocation for gold, but we’ve been buying it tactically for about the last year or so. There’s almost no opportunity cost if there are [near] zero interest rates on Treasuries, and gold is one of those [assets] that has the right correlations—it’s positively correlated to equities when the market is going up, and negatively correlated when equities are going down. That gives it nice properties from a diversification standpoint.
Given that you’re still overweight on equities and see opportunities in that asset class, what is your outlook for the stock market on a sector-by-sector basis?
A sector that we’ve been very positive on has been health care. It’s had its own choppiness amid questions about changes in health care policy, but we do think it’s one of the few areas of the market with sustainable growth, and it’s relatively attractive from a valuation standpoint.
One area that’s been painful as of late has been financials. With the recent market correction, there are some pretty attractive businesses that we think will be poised to benefit on the upturn, and which now have more attractive valuations.
And another area is utilities. We were underweight on them for a few years but are now looking at the current market environment relative to interest rates that have fallen. We think the dividends are more durable than in other industries.
What about real estate? You’ve previously spoken of State Street building a position in publicly traded real estate investment trusts (REITs)—but given the struggles currently facing the world of brick-and-mortar real estate, are you still optimistic on that sector?
At the moment we are still overweight; if anything, we have added to our position in REITs. Selection matters a lot. Warehouses continue to be an area where there are attractive valuations, as is multifamily [residential real estate]. Retail is an area that we’ve been less interested in for a long time; malls have been under pressure well before COVID-19.
What I think this crisis is leading us to do across our entire book—whether it’s real estate or anything else—is pressure-testing all of the assumptions that underlie our cash flow. There are companies that may have been cash-flow-positive historically, but what’s the burn rate right now? How is each company responding, whether they have lines of credit or are doing things proactively to measure cash flow? Our teams are looking at that very carefully right now.
What’s your perspective on the historic measures taken by the Federal Reserve to stabilize the financial markets and keep credit flowing? How important were those measures as far as assuaging investors’ fears amid severe market volatility?
Our view is that the Fed’s expansion of its balance sheet is significantly more important than its reduction in interest rates, at least right now. The fixed-income markets were seizing up; there were no bids to be found, even for Treasuries. It was an extraordinary market where you couldn’t sell even the highest quality assets for any price—that was unheard-of for Treasuries.
The fact that they extended, and continue to look at extending, to other niche areas—even municipal bonds—is also critical. We’re in an environment where there’s not a credit crisis—at least not yet—but there is a bit of a solvency crisis in the sense that investors cannot exit positions that create their own kind of panic. We’re heading to a quarter-end where we may see a rebound, and most investors are going to want to sell fixed-income [assets] and buy equities. If they can’t sell, and have to do so at draconian costs, it’s going to be disadvantageous.
The Fed had their Mario Draghi “Whatever it takes” moment, and at least that restored some degree of confidence in the credit markets that there was a buyer of last resort, even for assets that they historically have not supported. The U.S. credit markets have traded in a much more orderly way on the back of that.
Yet there continue to be concerns about the state of the corporate credit markets—particularly the sheer volume of BBB-rated investment-grade debt, much of which could be downgraded to high-yield, junk bond status should economic conditions continue to worsen. How concerned are you about these dynamics, and what is your outlook on the corporate debt space at large?
We’re likely to have massive downgrades, which means by definition that the high-yield market will expand at a time when there’s less liquidity and less interest in buying high-yield bonds. You also have, in many cases, institutional investors in indexed products who become forced sellers in those environments. We’re very much watching that and trying to work with clients on whether there is flexibility to not divest.
But it’s also a great opportunity to upgrade a portfolio, if there are fallen angels that look more impressive from a high-yield perspective. It will be a challenge to navigate. Which are the businesses where you can say that this is a temporary disruption, and they can restore their credit ratings? Where are the areas [in the market] where there is access to low-interest loans? Government intervention will matter a lot.
The good news is that there isn’t a wall of refinancings [coming due]; it’s more about [companies’] ability to get to a more normal cash-flow environment. And covenants are another vulnerability. Banks don’t want to throw companies into default right now—they have huge exposures, and that’s one of the big vulnerabilities for the banks.
How have your clients been responding to all of this market volatility and the fear that we’re slipping into another recession? As investment managers, how have you looked to assuage their concerns and guide them through these conditions?
Most institutional investors have been almost trained not to think about tactical allocations; the vast majority are following their investment policies and staying invested. The one thing we’re having a lot of conversations about is quarter-end rebalancing; depending on how [clients] were allocated, they’re looking at a rebalancing of decent magnitude at the end of the [first] quarter. In some cases, we’re looking at a selective rebalancing of some asset classes and not others, and what that means from an overall profile perspective.
One of the things we’re doing is spending time on participant communication. [Clients are] going to get quarter-end statements and see declines in their balances; how do they stay buckled in? I know I’m not looking at my statement [laughs].
Lastly, what advice would you have for young people entering or starting careers in financial services, particularly at such a historically volatile time?
The most important lesson that I ever learned was to know your stuff—know your facts, be a student, and don’t just read the headlines and assume that gives you the information you need.
And be bold. These are the kinds of environments where our clients are looking for advice. Do the homework and create the scenarios and make the judgments, and most of the time, that will serve your clients well. Be a student, learn—and if you feel you’ve done enough research, be bold enough to put a view out there and defend it. That will serve you well.
More from Fortune’s Q2 investment guide:
—5 rules to guide your investing decisions during the coronavirus pandemic
—Market preview: What to remember as we move past a quarter to forget
—Chasing returns: Why ‘inside the tent’ assets like corporate debt may be poised to outperform
—Best stocks to buy now: These 5 names will weather the coronavirus pandemic
—Why a bear market is the best time to ‘convert’ to a Roth IRA
—The health of the economy in 7 charts
—How to adjust your 401(k) during a bear market
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