From Nathan Shetty, Head of Multi-Asset, Nuveen
Key takeaways:
- Previously effective investment strategies may have limited utility in the new environment. A more rigorous approach to diversification and risk management is now essential.
- A considerably more dynamic approach to asset allocation is paramount. Country-specific risk profiles are changing and global investors should avoid taking on more risk than they need.
- Real assets should have a more prominent role in diversified portfolios. They are less susceptible to inflation, participate in secular growth trends and offer idiosyncratic risk exposure.
Nine implications
Nuveen has released a paper that explores nine implications that can help empower investors with the agility needed to navigate the uncertainties of the new economic environment. These are summarised below:
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- Reframe resiliency after decades of distortion – The great moderation was defined by suppressed macroeconomic uncertainty, low and stable inflation, a long-term decline in interest rates and reduced business cycle volatility. These conditions are unlikely to be repeated. Going forward, the very strategies that were laggards during the era of loose money — value investing, long volatility, floating rate securities, commodities and other real assets — will all play a more constructive role in diversified portfolios.
- Beware the declining utility of global cap-weighted allocations – Investors are keenly aware of the growing role geopolitics are playing in driving risk, as evidenced in our EQuilibrium survey results. From a portfolio construction perspective, global market capitalisation-weighted indices will likely be suboptimal vehicles to achieve geographic diversification in the new environment. Instead, investors can more effectively build their geographic allocations by placing a greater weight on the economic forces that drive a country’s or region’s market risks and return.
- Respect the limits of central banks’ power to control inflation – While the outlook for inflation is still on the minds of investors, it is no longer their predominant concern, the EQuilibrium survey shows. Investors headed into 2024 have either already adjusted their portfolios, felt optimistic about central banks’ responses to inflation, displayed an element of recency bias, or some combination of these. Four structural trends will impede global central banks from achieving their low targeted rates of inflation: de-globalisation; energy transition; aging demographics; and deficit spending.
- Artificial intelligence is a double-edged sword when it comes to inflation – Despite AI’s enormous potential as a productivity enhancer, investors should not take for granted that it will completely offset the wide range of inflationary tailwinds. AI requires a massive amount of computing power, consuming exorbitant amounts of materials, physical space and energy — real-world inputs that are in limited supply. AI proliferation is also likely to drain highly skilled labor from other productive areas of the economy given the need to engage in the AI ecosystem.
- Rethink government bonds’ role in portfolios – Higher structural inflation brings about positive stock-bond return correlations. The negative correlation between stocks and government bonds over the past 20 years has been the exception, not the rule. Even moderate levels of inflation are enough to bring us back to a normalised environment of positively correlated stock and bond risk premiums. Given that we are unlikely to repeat the great moderation, investors seeking greater diversification may benefit by looking beyond government bonds.
- Do not take more risk than you need – When risk-free rates were negligible — and in some cases even negative — institutions struggled to find assets that would deliver returns high enough to meet their objectives. Today’s environment creates a greater need to adopt a more nuanced approach to diversification and risk management and, as we discuss later, a more dynamic approach to strategic asset allocation. Analysing portfolio risk factor exposures will become increasingly important in the new regime.
- Privates are not compelling just because they are private – Adding allocations to private assets based on the asset’s ability to deliver an idiosyncratic exposure not replicable in public markets is an effective approach to optimising a portfolio’s illiquidity buckets. Investors can also employ private markets to extract value from deal sourcing, operational improvements and structuring expertise. Investors may be better served by focusing on these private market value adds rather than the often-cited illiquidity premium, which is difficult to estimate and varies over time, or volatility-suppression, which is more a reporting construct than a reflection of risk.
- Appreciate the scarcity value of real assets – Real assets strengthen traditional portfolios by delivering attractive returns in environments that are often detrimental to financialised assets, such as listed stocks and bonds. This is because much of their value is derived from their scarcity — the supply of tangible assets is inherently limited.
- Be active where you can have the greatest impact – Investors seeking to enhance portfolio resilience are best served by taking a dynamic approach to strategic asset allocation, in addition to tactical allocations and security selection within asset classes. A ‘set-and-forget’ approach to asset allocation is unlikely to thrive. Expected risks and returns, which are driven by a common set of macro factors, are changing. This warrants more dynamism in the strategic asset allocation.
