Investors could be forgiven for entering the New Year with an uneasy feeling. Inflation, although expected to fall, is likely to remain elevated this year and interest rates are on track to rise. These two factors would force investors to adapt their strategic asset allocation to the much-touted term ‘the new normal’.
This, one would assume, should mean a shift to less riskier assets. But as this year has progressed, investor caution has been followed by a paradox. While one would have expected investors to sell risk assets, stock markets rose. After an abysmal 2022, the FTSE100 hit a record high in February, while the S&P500 is up 7.6%, year to date
At the root of this ambivalent investment outlook is uncertainty about inflation. The Bank of England and the Fed have stressed that they expect the cost of goods and services to fall, but that further rate hikes might be required to achieve it. Markets appear to have swallowed the good news in this message, that inflation could fall, without considering the words of caution about future rate hikes. As recently as January, markets priced in that US Federal Reserve rates could peak in March.
This has now been adjusted somewhat, amid a strong job market and news that inflation in February shrank slower than anticipated. Nevertheless, futures pricing suggests investors believe rate hikes could peak this summer. Are they being too optimistic? For institutional investors having to reposition their asset allocation for the long term, what will happen to inflation and, in turn, to interest rates has now become the all-important gamble.
The inflation issue
Richard Tomlinson, chief investment officer of Local Pensions Partnership Investments (LPPI), confirms that investors must navigate two potentially different outcomes. “The conversations 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 inflation, less geopolitical co-operation, shorter supply chains concentrating 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 England’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 deglobalisation could mean we are entering a period of persistently high inflation.
Dan Mikulskis, a partner at consultancy Lane Clark & Peacock, says the ‘new normal’ term may be overdone, but it has substance. “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 different 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 control,” 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 liabilities. 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.
This means investors are increasingly turning to debt with shorter maturities, Mikulskis says. Short-dated, high-quality corporate 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 private 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 Matthew Cox, investment director at the Esmée Fairbairn Foundation, 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.
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 But Roe does not dismiss alternatives entirely. “If and when these growth assets re-price, then yes they could be interesting,” he adds, “in offering a high initial real yield and some sort of contractual, or at least approximate, inflation hedge to the heightened uncertainty investors face.”
The great transition
While fixed income is becoming more attractive, demand for alternatives continues to rise for open schemes such as the LGPS pools and charities. Infrastructure, property, healthcare and higher-income long-term real assets are proving attractive in the current environment. “We are looking at some of these [assets], particularly in relation to the transition to a low carbon economy,” Esmée Fairbairn’s Matthew Cox says.
The shape of private market assets also appeals to George Graham, fund director at South Yorkshire Pensions Authority. “Certainly, they are a key emphasis in our overall investment strategy and will likely be areas into which cash flows in the coming years, in part because of their strong income characteristics,” he says, adding: “The problem, of course, is that this could result in prices being bid up potentially eroding returns in the short term.”
This poses a natural dilemma for pensions funds like South Yorkshire’s. Graham expects further asset allocation modifications to his fund. “We see some shift into alternatives although we don’t make big allocation shifts. Listed equities will have a key role in the portfolio, as we remain an open scheme we need to maintain an exposure to growth assets,” he says.
Cyclical headwinds
Illiquid assets also come with risks, especially if the economy takes a turn for the worse. Property could also prove a safe investment option, Mikulskis says. “UK property saw some quite big falls toward the end of last year, but there are some real cyclical headwinds there, such as the decline of the high street and changing use pattern of offices.”
Mikulskis recognises that infrastructure has been a popular asset class. “And if anything,” he says, “an issue in the UK has been a lack of supply of projects at good return levels.” How this can be addressed is still open to question. He also notes that privately owned infrastructure assets have held their value pretty well over the past year, adding: “That makes them a candidate to rebalance away from where possible, rather than add more due to overall portfolio allocations.”
For pension funds there are other considerations beyond what looks good from an investment point of view within a portfolio. Graham says this is the case for local government funds like South Yorkshire. “For LGPS funds we also need to consider the implications of the Edinburgh reforms and the steer from the government in terms of ‘levelling up’ investment, as well as any changes in the pooling guidance.”
Go forth and diversify
The whole debate raises bigger questions about diversification within a portfolio. “A core belief for us is that diversification needs to be much deeper than just equities and bonds,” Roe says. “So, including alternatives and also ensuring that within asset classes there isn’t too much risk in one region either.”
With higher volatility, diversification becomes particularly important – by asset class, regional risk exposure, currency and avoiding too much exposure to one stock or sector. “The main three economic blocks of North America, Europe and China face different challenges and upside opportunities,” Roe says.
He, therefore, offers another perspective for investors to consider. “All else equal, investors should aim to be contrarian,” Roe says. “This will mean they tend to buy assets after they fall in value and avoid jumping on the bandwagon of assets that have recently done well.” But Tomlinson stresses the limits to diversification. “You cannot have a portfolio for every scenario,” he says. Last year LPPI undertook a war game scenario in which the investment committee raised many of these issues. “The conclusion was to be cautious on liquidity,” Tomlinson says.
There is a sense in all this that it can become something of a continued argument about an investment portfolio. But keeping the long-term in mind remains crucial, Tomlinson believes. “We have to plan for the new normal if we want to be standing in 10 years’ time,” he says. This highlights that investors cannot, and should not, ignore the challenges – and with it opportunities – offered by the new normal.
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