Multi-asset investing in fast-moving times

Diversifying portfolios has become harder as equities and bonds have become increasingly correlated.

In the decades running up to 2020, the 60/40 approach to portfolio construction, using bonds to diversify equity worked particularly well, as bonds and equities were negatively correlated.

But in 2021 and particularly in 2022, bonds failed to provide the diversification of returns seen in many prior years. 

As James Klempster, deputy head of the Liontrust multi-asset team explains, this was fundamentally the result of an exceptional set of macroeconomic headwinds that saw inflation soar to 40-year highs.

Klempster adds: “Since the global financial crisis, the bond risk/reward equation has been distorted by quantitative easing and zero interest rate policy. 

“However, this is no longer the case and central banks now have the monetary tools to deal with the next crisis, while balanced portfolios have the downside protection from bonds.”

So while the investment landscape may have improved somewhat, is it plain sailing for multi-asset investors, and how easy is it to diversify a portfolio?

Liquidity issues

Darius McDermott, managing director at Chelsea Financial Services, says: “Very few assets have been able to escape the liquidity drain of higher yields and quantitative tightening. 

“This is the deflating of the massive asset bubble that was formed in the years prior from quantitative easing and low interest rates. In this environment, it has been very hard to diversify. However, we still think it is important to do it.”

Klempster says diversification will require greater flexibility over asset allocation and access to more asset classes.

He adds: “The increasing complexity and velocity of today’s financial markets present many challenges and opportunities for investors. Over the next decade, the drivers of successful investing will be different from those of the past 10 years.”

David Jane, a fund manager in Premer Miton's macro thematic multi-ssset team, says: "The 60/40 approach to [portfolio] construction, using bonds to diversify equity worked particularly well for the decades up to
2020. 

"This was because of ultra-low inflation and rates. This era has now passed and we are back to a more normal environment where equities and bonds positively correlate. 

"Hence we need to use bonds primarily for low volatility and income, particularly at the short end. In the long term, diversification will come from a blend of equity, short-dated bonds and real assets such as property and commodities."

The economy

In the UK and Europe, economic leading indicators are weak and weakening.

Lindsay James, investment strategist at Quilter Investors, points to market data which shows that in the UK the effective interest rate on outstanding mortgages is at 3.14 per cent, while the average quoted rate for new or refinanced mortgages sits at around 5.5 per cent.   

With around 30 per cent of mortgages due to be refinanced over the next two years, homeowners are still likely to face a painful upward adjustment of their payments, acting as an ongoing headwind for the domestic economy. 

And while Europeans enjoy much longer-term fixed-rate mortgages, as they do in the US, the European economy is nevertheless evidently struggling, particularly due to the global downturn in manufacturing that shows little sign of abating. 

This, James says, explains why the International Monetary Fund projects GDP growth in the UK to be just 0.6 per cent in 2024, with clear risks to the downside. 

Not all bad news

For investors this is not all bad news. James says: “Should the economy be even weaker than is already anticipated, it could bring inflation to heel more quickly and allow more significant cuts to interest rates. 

“We have found that, historically, when the Bank of England has cut interest rates following the end of a period of interest rate rises, returns have been particularly strong in the year after.   

“Following the first cut in rates in 1990s, the MSCI UK Index returned 46.1 per cent over the next 12 months. In contrast, the US economy remains on a higher path and there is no certainty that earnings will in fact be weak in 2024. The jobs market continues to be strong while real disposable incomes have been growing.”

Protecting against inflation

It is true that inflation is currently flat in the UK, but it is still too high.

To protect against inflation in a multi-asset portfolio, energy assets and commodities can help, according to investment managers.

McDermott says: “The best protection against inflation has historically been energy stocks, so it might be worth having a little exposure to these. Treasury inflation-protected securities (Tips) or Linkers are another good option now. 

“They were a terrible option last year when real yields were negative and they massively underperformed as a result. However, now you can lock into safe real yields of 2.5 per cent. 

“This is a good allocation as part of a balanced portfolio in our view. Gold is another traditional hedge against inflation.”

Jane says a balance of short-dated bonds for income and stability and a focus of value, such as resources and energy in equity, with some commodity exposure should perform well.  

Jane adds: “In an inflation environment there tends to be greater volatility, bonds tend to underperform real assets and commodities do well. Within equity, value and asset-based businesses do better than growth companies.  

“We wouldn’t dismiss those companies with pricing power such as the US large-cap tech monopolies.”

According to Liontrust's Klempster, if investors are concerned about whether their returns can exceed price rises then the current rates of inflation and interest rates mean they must look to non-cash assets if they are to have a prospect of doing so. 

Additionally, the shortfall of cash versus inflation on current rates will only be exacerbated the longer that investments are parked in savings accounts that pay negative rates versus inflation.

Klempster adds: “Cash plays a role in balancing the risks in diversified portfolios, but the world offers a much wider choice of investment assets with the potential to enhance long-term returns. 

“The evidence points to equities being the best way to beat inflation over the long term, which lies at the heart of our own portfolio construction. The key issue for investors is to balance the asset mix to ensure it matches their own risk profiles.”

Protecting portfolios

At Quilter Investors, James says that while they have a range of tools to consider, they can only play a part, and do not fully offset the impact of inflation over a short time period.

She adds: “What is more reassuring is that over longer time periods, such as five years, data shows that large-cap stocks can do a much better job of beating inflation than cash. So the first way to protect against inflation is to remain invested.”

At the portfolio level, James says the first defence would be at the asset class level in considering the optimal allocation to government bonds in particular, which typically bear the brunt of rising inflation and higher base rates. 

She adds: “We have been underweight this part of the portfolio for some time across our product range but are finding more attractive opportunities in this area given the level of yields now on offer. 

“While bond yields are higher, giving more potential for capital appreciation in a growth shock, this is contingent on inflation continuing to fall, otherwise rate cuts may not be forthcoming, so searching more broadly for portfolio diversification is important.”

Within the equity space, James says quality stocks are best placed to weather the storm of inflation, as these businesses can typically pass on higher input costs to customers without suffering an ensuing hit to demand. 

She adds: "They may own a ‘must-have’ product or have a degree of market dominance that is hard to dent; companies like Microsoft and Alphabet spring to mind here.

"Also in the equity space, listed infrastructure assets can also see a degree of inflation protection; on one hand, higher bond yields reduce the value of their future cash flows, but those cashflows typically have a degree of inflation-linkage in their nature.

“Finally, alternatives provide a range of assets that help to protect against inflation. Commodities might fit in here and typically act as a good diversifier in a high-inflation environment. There are also hedge fund strategies such as global market funds and market neutral funds that have done well against the inflationary backdrop.”

Corporate pressure

When it comes to corporate bonds, investors have been used to very low defaults for a long time as companies have been able to muddle through.

But the impact on companies as they refinance to higher coupon rates means more companies will become distressed and go bankrupt as they approach refinancing, McDermott says.

Higher interest costs are likely to put the brakes on expansion plans as companies will have to pay more in interest and will be wary of taking on more debt. 

But the picture will not be the same for all companies.

Premier Miton’s Jane says that for the vast majority of large-cap companies, debt burdens are not an issue. Indeed higher rates have come with higher inflation and hence higher revenue.  

He adds: “For smaller companies these typically finance with bank debt at variable interest rates, so here the pain has already been felt. The problems will arise as more risky companies, such as leverage buyouts, have to refinance in the bond markets.  

“These will really hit it in the coming years and may prove painful or even terminal for some. We avoid the highest risk parts of the bond market, particularly leveraged finance.”

Quilter’s James notes that investors have been needing to delve into balance sheets and ensure they fully understand the incoming impact to interest costs. 

She adds: “The implications of debt refinancing are going to differ sharply depending on balance sheet strength and the underlying maturity of the company’s debt arrangements.”

Typically, small caps have a far steeper refinancing ‘wall’ as bond maturities have been shorter, while large caps have been able to use the long period of cheap money to lock in low rates for some years ahead. 

Furthermore, big tech can go one better given the massive cash piles that companies such as Apple, Alphabet, and Microsoft enjoy, notes James.

“Perhaps partly explaining why the mega-cap equities, which are typically growth stocks, have performed so well in 2023 despite the backdrop of rising bond yields,” James adds. 

“This has already been a factor in performance with MSCI World Small Cap index delivering -3.84 per cent so far this year (to October 31) while MSCI World Large Cap index has grown 9.22 per cent, arguably suggesting that a large part of this refinancing risk is perhaps already reflected in share prices.”

Arguably, we are through the worst of inflation, and it is anticipated that inflation will continue to fall, as the rolling base effects from Covid shutdowns and Russia’s invasion of Ukraine work their way through the system. 

Klempster says this should allow central banks to tread carefully and be less aggressive on the hiking front, but adds that there also remains a risk of policy surprises or unintended consequences, neither of which are supportive for markets.

He says: “For long-term investors, there is a need to embrace volatility and it is likely that over the coming year there will be periods of below average trend returns, similar to those seen in 2022. 

“However, with the repricing of bonds and equities it may be a good time to look again to balanced portfolio investing. Claims of the death of the 60/40 approach may be premature.”    

Meanwhile, McDermott argues the 60/40 approach is "overly simplistic and misses out on great return and diversification opportunities".

He adds: "We love the alternative investment trust market. Despite its recent challenges we still very much believe in it. We love being able to put different assets in the portfolio at high yields with little correlation to the economic cycle.

"While capital values may move around, we tend to focus on the sustainability of income and we need something more than just traditional equities and bonds to achieve that, and Covid proved this when many equities cut their dividends.

"Investors also need to be wary of liquidity mismatches when accessing more esoteric or less liquid assets."  

ima.jacksonobot@ft.com