Investors are facing a new paradigm according to Bridgewater Portfolio strategist, Atul Lele, in which diversification is both more important and more difficult than ever in a global environment where there are “risks everywhere”.
Speaking at Investment Magazine’s annual Absolute Returns Conference he also said the traditional 60/40 portfolio had seen its day, as using bonds as a diversifying factor was becoming more and more difficult.
And, if the investment landscape wasn’t difficult enough amid ultra-low bond yields, the potential end of a record-breaking equities rally and with inflation looming its possibly ugly head, things may be getting even harder.
When you look at bonds in terms of providing a buffer for portfolios, he said, in Europe we’re “basically done”, the U.S. had maybe one more move and Australia also had maybe one more move before hitting zero bound.
Also speaking at the conference, Newton Investment Management’s portfolio manager Aron Pataki said: “Government bonds after 30 years of providing equity-like returns with much lower volatility now offer, respectively, equity-like volatility but potentially lower returns… [so] they look unattractive. Government bonds are unlikely to buffer market losses.”
“Monetary policy three” and a new market regime
Further complicating the investment landscape Lele said, is the fact that the pandemic accelerated the shift to a new policy paradigm that he referred to as “monetary policy three: huge spending by government, fiscal policy financed by monetary policymakers”.
“[A] feature of the new market regime is you’re approaching zero [bond yields] across reserve-currency countries. And that comes against the backdrop of an extraordinary equities rally that… benefit[ed] from dynamics that aren’t likely to persist, and… a turning point in inflation where the secular forces of disinflation are fading or indeed turning in some cases,” he said.
He added policymakers have shifted from looking at targeting inflation on the outside to now averaging inflation, which, mathematically, means we’ve got to spend some period above target. We’ve seen that from the Fed, from the ECB, and other central banks around the world, even some in emerging markets… we’re now in a money printing environment.”
Inflationary pressures
Pataki said Covid was a significant inflationary shock to the system and, amid the pandemic, inflationary pressures were initially related to supply chain bottlenecks and commodity prices but he expected inflation to remain elevated even if these factors moderated.
“[The] Covid-19 recession was the only recession in modern history where personal incomes went up rather than down, that’s the main reason why the economic recovery has been so robust,” he said.
“I think it’s right to see goods inflation as transitory… I think that will wane to some extent because supply chains will resolve [but] I think there will be a second inflationary [wave] driven by wage inflation [from a tighter labour market] which will translate into higher core services inflation. And I think this is trickier to control and I think that this will potentially demand a policy response.”
He added that the Covid crisis had increased the tolerance of authorities for higher inflation and the “gloves were off” in terms of spending, saying that a large part of this spending would be in the green energy transition space, not just in the developed world but also in emerging markets as well.
“Companies that play into the green energy theme will benefit,” he said.
So how did we get here?
According to Lele, secular challenges have been rising for decades, predating the pandemic, including a massive rise in public and private debt and we’ve also seen developed world policy makers left with very little “fuel in the tank” as interest rates have hit historic lows.
The ability to stimulate through traditional means is very clearly coming to an end, he added.
“The Reagan and Thatcher era policies and pro-corporate policies have contributed towards the largest degree of wealth inequality that we’ve seen since the 1930s,” he said.
The result of the new paradigm is that from an alpha perspective, investors are facing an unprecedented environment that no investor over the past 40 years has seen.
So what should investors do?
“Firstly, it’s thinking about alternatives to cash… the value of cash has been devalued by central bankers,” Lele said.
“Secondly, it’s thinking about… diversification across different economic environments, recognizing the last decade of the pro-corporate liquidity disinflationary environment may not continue,” he added saying there was also a need for geographic diversification in a world that is becoming increasingly tripolar with Europe and China becoming major players along with the U.S.
“From an alpha perspective, it’s never been more important to find that broad and uncorrelated alpha and broaden the sources of potential alpha to alpha streams such as defensive alpha, which can be very valuable in this type of environment,” he said.
China is at the centre of an increasingly important Asian economic bloc and that bloc is now equivalent in terms of its share of global output to the U.S. and Europe, Lele warned.
“What we’re seeing is that the independence of China’s domestic economic conditions, the independence of the monetary impulse and monetary policymakers is contributing towards an independent risk premium that’s now available to investors. And that’s a highly diversified risk premium to most traditional portfolios,” he said.
There is also still room for Chinese nominal bonds to be able to fall in terms of yields moving down and this is incredibly important because it comes against that backdrop of an equity market that has had an extraordinary run, Lele added.
He said that thinking about nominal bond exposure in China was something that offered geographical diversity and one of the first “levers that you could pull” but another one was thinking about which assets could be constructed that could serve the role bonds traditionally had played in portfolios.
“We’ve developed, for example, trends such as stable cash flow equities, identifying those equities that have more stable sources of income… that’s something as well, strategically that investors can look at adding to their portfolios,” he said.
Investment toolkit
Brad Bugg, head of multi-asset portfolio management at Morningstar asked Lele at the conference what would be in his investment toolkit now that we’re heading into a post-pandemic world.
“Across most of these environments, where policymakers are engaged in these types of policies, massive monetary and fiscal coordination, the two types of assets that tend to do well… are inflation linked bonds and gold: the two assets that most investors hold very little of. Or even in the case of gold, some investors hold none. Diversification becomes incredibly important, especially to those types of assets,” he responded.
Geopolitical risk
When asked about geopolitical risk and investing in China, Lele pointed out that at the moment there was “risk everywhere”.
“There are huge risks about investing in developed markets right now… large debts… massive inequality, huge levels of conflict,” he answered.
“[But with regard] China’s recent regulatory measures, we can connect them back very, very clearly to China’s goal, in terms of developing its economy [and] the commitment to continue to reform and open up capital markets. [Recently], there was the opening up of a new stock exchange as an example of that commitment. And so we can view that common prosperity as being something that’s aligned with China’s goals.”
