Cover story – Asset allocation
tions I have had internally have been on at least two scenarios. One is, are we going back to the great moderation of post 1982: characterised by falling inflation, lower rates, everyone playing nice globally and supply chains that work?” Then there is the second scenario. “This is where there is infla- tion, less geopolitical co-operation, shorter supply chains con- centrating on security not cost and onshoring. If we go down that road, we will have some serious questions.” At the heart of the uncertainty is the question of whether we are about to enter a ‘new normal’ of persistently high inflation. Central bank forecasts suggest otherwise. The Bank of Eng- land’s February monetary policy report predicts that inflation will fall to 4% later this year and settle at 1% in the first quarter of 2025. But there is also a view that the climate crisis and de- globalisation could mean we are entering a period of persis- tently high inflation. Dan Mikulskis, a partner at consultancy Lane Clark & Peacock, says the ‘new normal’ term may be overdone, but it has sub- stance. “Phrases like ‘new normal’ have become a cliché in investment, and often it is the sort of noise that long-term investors need to look through. That said, some significant things have objectively changed.”
Like much of the new normal, there is not an exact consensus on all its component parts. Mikulskis, for example, offers a dif- ferent take on inflation. “Inflation has obviously been a big driver of the last couple of years, but one interesting feature has been how quickly markets expect it to come back under con- trol,” he says. “Market pricing does not anticipate structurally higher inflation being a big medium-term part of the picture.”
A view not shared by John Roe, head of multi-asset funds at Legal & General Investment Management. “For us, the new normal isn’t higher inflation,” he says. “The initial shock has already peaked and we could even get low inflation in 2023. For us, the new normal is high uncertainty and higher nominal and real bond yields as a starting point.”
The right mix So, how should the asset allocation mix alter for investors? From a macro perspective, if inflation were to fall, now might be the time to lock in relatively attractive rates in fixed income, John Roe says. “We need to be concerned about inflation risks, but equally bonds can provide better returns in a recession where central banks cut interest rates,” he adds. “In the next 12 months, we could see anything from a global recession, a rebound in economic growth or another inflation scare.” This could be good news, especially for insurers and defined benefit pension funds looking to match their long-dated liabil- ities. But the flipside to that is if inflation and rates continue to rise, investors in long-dated debt may have locked themselves into duration risk.
For us, the new normal is high uncertainty and higher nominal and real bond yields as a starting point.
John Roe, Legal & General Investment Management
This means investors are increasingly turning to debt with shorter maturities, Mikulskis says. Short-dated, high-quality cor- porate bonds yielding north of 5% a year set a high hurdle for riskier assets and alternatives to merit inclusion in a portfolio. “After a decade of scouring the markets for good ideas in pri- vate markets and alternatives in a world of zero interest rates, you have a situation where more straightforward assets can do a great job of meeting investors’ return targets,” he says. Another area of concern is the increasingly positive correlation between stocks and bonds, which is high on the agenda of Mat- thew Cox, investment director at the Esmée Fairbairn Founda- tion, a charity working to improve the quality of life. He reveals that in the past, his team has held little in terms of fixed income due to high valuations. “But, after the corrections in 2022, we are hoping there will be more opportunities in this area. It has been a challenge for a long time now to find attractively priced assets which provide good diversification against equities,” he says. Roe adds that factoring in pricing, fixed income could become more attractive compared to alternatives. “To some degree, these types of assets compete with index-linked government bonds which also offer long-dated real returns only with lower returns and less economic risk. These other assets are riskier than bonds, so should offer a significantly higher return.” For example, in 2022, 20-year real yields on US index-linked bonds climbed by more than 2.25% while in the UK they jumped to more than 3%. This could make inflation-linked debt relatively more attractive than alternative assets that come with higher fees and liquidity risks.
18 | portfolio institutional | March 2023 | Issue 121
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