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This quarter, my focus is on how to make sense of the current market environment. In particular, are we at a “pivot point” from one market regime to another and, if so, what does that mean for asset allocators in regard to portfolio positioning? Looking at previous market environments that resembled today’s, we find that they were often tied to regime change. For example, recent research from our Investment Strategy team shows that the historical period most similar to today’s was the first quarter of 2001, which turned out to be a pivot point between the pre- and post-dot-com eras. I think it’s very possible that we’re witnessing another such transition today, with meaningful investment implications.
In thinking about this topic, I was fortunate to be able to leverage the work many across our firm have done on regime change and historical comparisons between market environments. For example, Scott Elliott, a recently retired Wellington colleague who ran multi-asset strategies for nearly 40 years, focused on what he called “investment leadership cycles,” which are defined by distinct market leadership (sector, region, theme) over an extended period. During these periods, a specific group of companies rises to become the largest in the world (e.g., Japanese banks during the 1980s or the first generation of internet leaders in the late 1990s).
Scott drew many lessons from his cycle research, including the fact that cycle leaders are often unexpected and paradoxical in nature — i.e., they didn’t always flow logically from the prior period (more observations from Scott’s research are listed in Figure 1). My key takeaway, which informs the ideas I outline below, is that allocators can’t assume they will find the narrow group of winners in the next cycle, but they can be careful about their exposure to the prior cycle’s winners. And, importantly, they can think broadly about which areas of the market are likely to offer more compelling returns in the new market regime.
With that in mind, I want to delve into five areas where the world may be very different in the coming years — inflation, the business cycle, interest rates, stability/value, and active management — and how allocators can prepare.
The unusually low inflation of the post-GFC period now seems like a distant memory. While I don’t expect inflation to remain at the highs we saw in 2022, I do think it could stay above 2% or even 3% over the next decade, driven by several sources of price pressure:
The end of the low-cost global labor boom — In the wake of the GFC, wage growth in the developed world was capped in part by a massive expansion in the pool of global workers, especially in China. I think that trend has largely played out. While there is low-cost labor in other parts of the world, these pools often lack the required infrastructure (capital, transportation) to help meet global labor demand.
The rise of onshoring/reversal of globalization — As countries rethink their supply-chain management (e.g., “critical supplies” onshoring in strategic areas such as health care), we will see cases of goods and services being produced in markets where it is less efficient to do so — activity that is inherently inflationary.
The expanding role of fiscal spending in economic policy — The pandemic drove an enormous fiscal spending binge, which likely can’t be pulled back all at once and, unless it’s offset, will add to the inflation pressure. It took central bankers far longer than expected to reverse monetary stimulus after the GFC, which makes me cautious in assessing how long it will take global governments to wean themselves off fiscal stimulus.
Underinvestment in commodity supply — The underinvestment in commodity supply over the last decade looks poised to continue as investors worry about the transition to a lower-carbon economy and the uncertainty it creates about future demand for energy and other commodities. As commodity supplies struggle to meet growing demand, price pressures will likely ensue.
Bearing these pressures in mind, I think the US breakeven curve (Figure 2) suggests a degree of complacency about the outlook for inflation. As of 31 October 2022 (orange line), the market expected inflation of about 2.5% over the next 10 to 30 years — above the expected level at the end of 2020 (dark blue line) but not by much.
Direct investment in real assets — Commodities have historically had a high beta to inflation, making them a potentially potent hedge. In addition, as Commodities Portfolio Manager David Chang noted in a recent article, we have seen marked improvement in the commodities roll yield, an important sign of the return commodities may provide. It’s also worth noting that commodities have tended to do well late cycle and early recession, at which point they may be effective diversifiers versus stocks and bonds. Those who aren’t comfortable investing directly in commodities might opt for a diversified real asset portfolio that includes, for example, commodities, natural resource equities, and TIPS.
Tilts to inflation-sensitive sectors — Within an equity allocation, there may be opportunities to add to natural resource equities, as well as other inflation-sensitive equities such as listed infrastructure (where companies can often pass inflation directly to their rate payers). As these sectors have become a smaller part of global equity indices over the last decade, investors’ overall exposure has declined. In addition, value stocks, given their shorter-term cash flows, may behave better than growth stocks in an inflationary world. On the fixed income side, inflation-linked bonds may not warrant a major allocation given current real yields, but they can provide the inflation pass-through some are looking for.
Risk management at the portfolio construction level — If we assume higher inflation ahead, it’s important to recognize that the equity/bond correlation may be quite different from recent years (a topic discussed in more detail below). Allocators should also consider their overall portfolio’s beta to inflation and whether it presents a level of risk that needs to be more actively managed.
Wellington Macro Strategist John Butler has been arguing for some time that we’re heading into a new regime with more volatility in the economic cycle (John shares his views here). Since the mid-1990s, the global economy has spent about 75% of the time in a “Goldilocks” environment marked by positive growth and disinflation (left-hand chart in Figure 3) and just a fraction of the time in what is arguably the most challenging environment: recession with inflation (lower right quadrant). With little reason to worry about inflation, central banks have been free to ease conditions whenever the economy has slowed — particularly since the GFC.
But this hasn’t always been the norm. There have been long periods when economic conditions shifted much more violently across environments (right-hand chart). With central banks now forced to wrestle with inflation again and at times accept slower growth in exchange, it seems very possible we’ll face a similar level of cyclical volatility in the coming decade.
Prepare stakeholders — Increased volatility often creates governance challenges. Anticipating this and sketching out a range of possible outcomes can help prepare stakeholders and avoid policy mistakes.
Retain diversification but stress-test correlation assumptions — While I would stick with traditional sources of diversification, they may be somewhat limited in their effectiveness — for example, stocks and bonds may continue to struggle at the same time when inflation concerns are paramount.
Seek “stability” in equities — With diversification in short supply, this may be a time to add potential sources of stability, and particularly within the equity allocation, which tends to be the largest driver of portfolio risk. Stability might be the third pillar in an equity portfolio, along with value and growth — a framework that could help boost portfolio resilience. There’s an adage that when growth is scarce, growth stocks outperform, and this was true for much of the last decade. Going forward, I believe, stability will be scarce and stable stocks are likely to outperform. In terms of specific types of strategies that fall into a “stability” bucket, low-volatility strategies may have a place, but it’s worth noting that they tend to be challenged in rising-rate environments. I would look to “compounders” (equity strategies focused on companies with high and stable free-cash-flow yield and the potential to grow modestly but steadily over time) and to defensive global equity strategies that seek to preserve capital in adverse markets while providing equity-like returns in up markets.
Think opportunistically and tactically — Volatile conditions often create market dislocations that opportunistic allocators can exploit by being providers of capital when it’s most in demand. Tactical asset allocation may also play a role, helping to tap into not just the big dislocations but also the smaller bumps along the way.
Consider hedging — This is about knowing your own risk tolerance and the point at which volatility would become uncomfortable and worth bearing some cost to hedge. Setting out a detailed hedging philosophy is key, recognizing that hedging comes at a cost and may not be suitable for many investors.
Figure out where hedge funds fit — The unconstrained nature of hedge funds means they can use many of the strategies I’ve discussed, including seeking stability at times, being opportunistic and/or tactical, and hedging risk.
There are several reasons to think we’ve seen the end of a 40-year downward trend in interest rates. Inflation is the key risk, but higher fiscal spending is potentially a big contributor as well (as we saw with the recent market response to the UK government’s spending plans). Declining foreign demand for a country’s government debt could be another source of upward pressure on rates, especially if fiscal plans create doubt about the market’s investability.
Find the right balance between risks and opportunities — Higher rates can certainly be a headwind for duration in portfolios and may suggest rethinking exposure in some cases. But for investors whose time horizon extends beyond near-term headwinds, higher rates may signal more compelling forward-looking returns to fixed income in coming years.
Seek fixed income complements — As I alluded to earlier, allocators may not be able to rely on bonds as diversifiers in a higher-rate environment if stocks and bonds are positively correlated as they’ve been over the past year. One trend we’ve seen among allocators in response is using hedge funds as a complement to fixed income that may help fill some of the same roles. Members of our Fundamental Factor Team recently published research on this topic — and, in particular, on the process of building a portfolio of hedge funds that is aligned with those roles, including return consistency, total return enhancement, diversification, and downside protection.
The team offers examples of how a factor-based framework can be used to design portfolios for different interest-rate environments. The hypothetical portfolio in Figure 4 is targeted to a rising-rate environment and includes, perhaps not surprisingly, a large allocation to Macro funds, along with a healthy allocation to Relative Value funds and modest allocations to Equity Hedge and Event Driven funds. As shown in the first line of the accompanying table, this portfolio’s results were most positive in environments with the biggest upward moves in rates. Read more about the team’s research here.
We’ve been in a period in which growth dominated, aided by innovation and technologies that transformed the economy and fundamentals. But as I’ve said before, there is clear historical evidence of a growth/value cycle (Figure 5), and so I expect to see value regain leadership eventually. And if we’re moving into a world in which stability takes priority over innovation, I think that would tend to favor value (as well as income).
Value — In this new world, valuations should begin to matter in a way they haven’t at times during the last decade. Value could provide a margin of safety when we’re in volatile markets, meaning that stocks with lower valuations should sell off less in some scenarios. In addition, the sector mix in the value universe, which tends to include areas like energy, natural resources, and financials, may be more attractive in an inflationary regime.
Stability — As I noted earlier, stability may provide another line of defense in a volatile world. Stability-focused strategies typically outperform when volatility is high and markets are struggling. (On a related note, our Fundamental Factor team provides some thoughts on the need for defensive strategies here.)
Income — Equity income hasn’t been an area of focus among allocators for some time, but that may change. The immediate cash flow may be more attractive in an inflationary world, but I also look to dividend growers as another source of calm in a storm: Companies that are able to grow their dividends over time may provide an element of quality and stability.
Growth — While we may be approaching a long-awaited pivot to value, it’s also important to recognize the uncertainty in the current environment. I think that argues for maintaining a growth allocation as part of a diversified portfolio. That said, allocators may need to consider a different kind of growth in the next decade — it might be steadier, self-financing, and less-speculative growth, for example. Or it might be growth driven by long-term thematic trends that will transform the way we live.
When it comes to active management, I’m obviously not an unbiased observer, but I do think that after a challenging decade for some areas of active management, the new environment that I describe above could make active management critical to an allocator’s long-term success. More uncertainty, both macro and geopolitical, should lead to greater dispersion across and within asset classes (e.g., at the regional and sector level). And higher market volatility may mean more crises (market or political), less liquidity, and more defaults and failures. These events could drive more dispersion within securities, creating opportunities for security selection in equities and credit. In short, I would expect a greater universe of opportunities for skilled active managers to identify winners and losers.
I’ve written about many active strategies already in this note, but I would offer a few other active management ideas for allocators to consider as the market backdrop shifts:
Macro hedge funds — Macro hedge funds can apply a variety of tools and strategies in an effort to take advantage of market dispersion and dislocations. (Read more on the topic in a recent article from my colleagues.)
Growth fixed income — Over time, higher, more volatile rates, more uncertainty, and less liquidity may create attractive opportunities for strategies focused on higher-return areas of fixed income, including credit, high yield, and emerging market debt.
Emerging markets — The past decade was good from an economic growth standpoint, especially in China, but that did not translate into particularly favorable results for emerging market equities. I would not be at all surprised to find that the results are much stronger in the coming decade.
Thematic investing — As I noted, thematic investing may let investors take advantage of long-term growth potential in a market consumed with near-term risks and volatility. In addition, as members of our Investment Strategy Team discussed recently, thematic investments may be less correlated to the cycle.
As Scott Elliott’s research suggested, investment “pivot points” don't come along that often, so this is an important time. That doesn’t necessarily mean that allocators need to rush or make portfolio positioning changes all at once, especially if the new market regime will be here for a while. But this may be the moment to begin putting a plan in place to address the likelihood of higher inflation, volatility and interest rates, and to contemplate the role of active management going forward.
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In a more volatile world, stability may take priority over innovation, and that, explains Multi-Asset Strategist Adam Berger, would tend to favor value stocks over growth stocks.