New market regime, new approach

In the first edition of Investment perspectives, we establish the ABCs of a new approach to building portfolios:

1. higher-for-longer policy rates underscore the Appeal of income;

2. investors should consider Breaking up traditional allocation buckets to get more granular;

3. and Coasting could prove costly – portfolios need to be more dynamic and nimble in this new regime.​

A new regime at play

Last year, we saw the new regime of higher macro and market volatility starting to play out. Central banks hiked rates rapidly in their fight to pull inflation down to their policy targets, but persistent inflation continued to surprise investors. We see inflation falling but staying sticky and well above the 2% target levels sharpening the trade-off central banks face between stabilizing prices pressures and growth. We see central banks holding rates higher for longer in the face of persistent inflation even as growth slows. 

This is the new regime at play – and we think it’s here to stay, as we stated in our 2023 Global outlook. This requires a new approach to portfolio construction. The traditional approach saw long-term government bonds work to cushion against risk asset selloffs, focused broad equity and bond blocks in public markets and relied on “set and forget” strategic asset allocations (SAA). This approach was built during the four-decade period known as the Great Moderation where stable activity and inflation fostered a sustained bull market for equities and fixed income. That era is over we think - and that’s why the traditional approach designed to work in the conditions that defined the Great Moderation is unlikely to work in the new regime.

A new approach

We find that in this new environment of higher volatility and inflation, changes to asset mixes can lead to much more varied portfolio returns than before the pandemic. Those using the traditional approach will have to tolerate more risk to achieve a similar return. ​

We estimate that the portfolios that outperform in this new environment are very different from portfolios built for the old regime. The SAAs delivered by our approach will differ significantly from traditional portfolios and span both public and private markets.​

The recent debate in portfolio construction has asked whether the 60/40 portfolio – where 60% of the portfolio is allocated to listed equities and the remaining 40% is allocated to broad fixed income – is the proper allocation in this new environment. We don’t think the debate is about the precise asset mix but rather about the portfolio construction techniques that arrived at solutions that we think are too simplistic.

Appeal of income
In practice, we see three implications of our new approach. First, we think higher interest rates have revived the role of income. We prefer short-term government bonds for income and stay underweight nominal long-term bonds. ​

Breaking up buckets
We think broad allocations to listed equities and bond indexes limit portfolios. We believe more granular strategic views – across sectors and within private markets – should be the building blocks for portfolios to help make them resilient in the new regime. ​

Coasting could be costly
The “set-and-forget” approach of traditional portfolio construction doesn’t suit a more volatile world, in our view. We think more dynamic and nimble portfolios will allow investors to make quick changes in response to new information and market shocks.

More dynamic strategic allocation
Our strategic tilts to select asset classes, 2018-2023

Our portfolio has become more dynamic in response to the new regime. See the chart above. It shows how our strategic tilts have changed more significantly and more frequently since January 2020 compared to what they did before. Take global investment grade (IG) credit, for example. In November last year, we added to our overweight in IG credit as we expected yields to rise and wanted to profit from widening credit spreads. Yet the sharp narrowing of spreads through Q4 2022 spurred a trimming of that overweight – a typically quicker response to our SAA preferences than we might have seen in the past.

Similarly on nominal government bonds, we were overweight going into 2020 before quickly moving to a maximum underweight position. We kept a sizeable underweight all the way through this new regime - even as some may have seen yields as attractive – preferring inflation-linked bonds and other income assets for diversification instead. We quickly shifted our portfolio to be more prepared for higher inflation especially as bond markets keep underestimating inflation’s persistence.

We think the new regime will bring about more market shocks and uncertainty, but it can create opportunities as well. That’s why taking a more dynamic and nimble approach to long-term asset allocations to take advantage of opportunities in a volatile environment and seeking out relative value opportunities will be key to maximising returns going forward. And that’s precisely where the ABCs our new approach to portfolio construction can help.