As investors face heightened inflation risk and other uncertainties, look beyond traditional investment buckets to capture alternative sources of returns.
In the throes of the pandemic, I discussed the importance of applying probabilistic thinking to portfolio design rather than making decisions on an assumption of a particular outcome. Investors face a similar dilemma today. The macro environment is in many ways no less uncertain than it was two years ago, and investors are grappling with building portfolios for a future that will likely be very different from the recent past.
Like the butterfly that flaps its wings and causes a hurricane halfway around the world, the nonlinear interaction of forces currently in play may have investment implications beyond what we can predict with confidence.
How can investors build portfolios to deliver true diversification in an uncertain environment?
Resetting long-term inflation expectations
As central banks ratchet interest rates higher to rein in inflation, certain forces are outside their control:
Since the 1980s, the size of the global working-age population has steadily risen. This kept wage growth in check, and the income and production from a younger workforce supported spending and consumption by the elderly. Now, populations are aging in most countries. Greater consumption by a Baby Boomer population will need to be supported by a smaller workforce that may demand higher wages. Meanwhile, increased government spending on healthcare and pensions may necessitate higher tax revenues or borrowing. These may lead to higher real rates and higher inflation.
The recent era of price stability was fueled by an influx of low-wage workers from emerging economies such as China, relatively stable geopolitics and an increasingly efficient global supply chain. However, after decades of squeezing efficiencies from the supply chain, companies are now shifting their focus toward adding resiliency. Meanwhile, trade policies are influenced by domestic pressure to bring jobs back home. Consulting firm McKinsey estimates that over a 10-year period, supply chain disruptions may result in losses equal to 42% of a year’s earnings (EBITDA). Companies will need to build redundancies into their supply chains as protection. This is likely to increase costs, which may ultimately be passed on in higher prices to their customers.
The United Nations estimates that $125 trillion of investment is needed by 2050 to keep long-run temperatures from rising more than 1.5 degrees Celsius, thereby avoiding potentially devastating consequences. The true price of carbon is not fully factored into goods prices or company valuations. Pricing in the cost of carbon transition could increase the cost of producing goods and offering services.
These three factors may reset long-term inflation to levels that are higher than recent historical averages. This increase is not priced into markets today. U.S. inflation markets expect longterm inflation to be around 2.5%. Investors assume that central banks will aggressively raise interest rates over the next 12 months, reducing demand sufficiently to bring inflation back to historical norms.
But central banks can’t control structural inflation forces. Their only credible path to bringing inflation in line with expectations involves tightening financial conditions to such an extent that demand declines and unemployment increases. This would lead to financial hardship for millions, as well as potentially unsustainable borrowing costs for individuals, companies and governments.
The other option for central banks is to accept higher long-term inflation and to tighten financial conditions just enough to cause a slowdown. This might lead to lower economic pain but would require repricing long-term inflation expectations. While this is a possible outcome, the path is narrow given inflation significantly above current policy interest rates.
Can we hope for a different outcome? We might hope for a world of increased productivity through innovation and infrastructure investment. We can hope the setbacks in global relations reverse course. And we can envision a more inclusive society, with reduced inequality and a more productive workforce. As someone wired to be an optimist, I hope for this scenario.
But hope is not an investment strategy. Demographics, deglobalization and decarbonization have the potential to drive structurally higher long-term inflation than markets currently expect. Investors need to be prepared.
How can investors prepare?
Inflationary forces are just a few of the butterflies whose flapping wings today will have uncertain implications for decades. What we can assess is the probability distribution of outcomes. In this assessment, traditional investment portfolios are vulnerable.
The near-term outlook for equities is murky. Most of the decline in equity markets this year can be attributed to investors repricing the impact of higher interest rates. An economic slowdown resulting in lower-than-expected earnings could present further risk to equities.
Timing the peak in bond yields will be difficult. Bond markets are pricing in a peak in 2023 followed by a corresponding decline in yields, potentially because the Fed, at that time, might be cutting rates to get the economy out of a recession. However, structural forces may keep long-term inflation elevated, and higher government spending on infrastructure and social safety nets for an aging population may lead to greater borrowing, which may lead to higher bond yields than what might otherwise be priced in.
Popular inflation solutions may not be as valuable. Commodities are highly volatile and have experienced 30%+ drawdowns during slowdowns. This makes an investor’s experience in commodities a function of when they allocate—get the timing wrong, and it could be a major detractor. Certain real estate strategies may benefit from inflation; however, real estate equity is likely to behave like equities in a macro slowdown, and it may therefore not offer as much of a diversification benefit.
Private markets will not be immune to economic volatility. Infrequent mark-to-market accounting methods used by private funds to value their holdings may smooth out reported returns in the near term. The investment acumen of a limited number of highly skilled managers may add excess returns (if you’re fortunate enough to have picked the right ones). Private investments may also offer potential diversification benefits, although in a hard landing, private and public markets are likely to share similar fates. Equity and credit are driven by the same economic forces whether they trade on an exchange or are bought and sold by appointment.
Therefore, most portfolios—including those invested in private market alternatives—may be overly exposed to a macro economic slowdown or higher inflation.
Investors seeking true diversification may need to look beyond traditional asset classes to capture alternative sources of returns. Over the coming decade, investors should consider adding strategies that derive their returns from truly alternative investment approaches:
- Long/short and options-based approaches capture alternative risk premiums from structural imbalances in commodity, currency and inflation markets and have historically delivered uncorrelated returns.
- Volatility strategies benefit from heightened risk aversion by investors.
- Macro and multi-asset relative value strategies provide returns from mispricing of similar risks across various asset classes.
- Machine intelligence identifies relative value opportunities in markets overwhelmed by narratives.
- Specialized alternative approaches access uncorrelated opportunities in real assets.
- Megatrends such as carbon transition may transcend the economic business cycle.
Accessing these diversifying opportunities will require moving beyond the traditional investment buckets and embracing other approaches that accommodate risk diversification or opportunistic allocations.
Over the past decade, investors benefited as a low cost of capital lifted all boats. Additionally, longer-term themes of innovation, globalization, and the fall of the Iron Curtain led to more efficient supply chains, lower inflation, and reduced geopolitical risk. Central banks, to their credit, also stepped in to prevent markets and economies from collapsing during times of stress such as the 2008 financial crisis or the 2020 Covid pandemic. These actions reduced fear, and increased risk appetite of investors helped fuel a technology-driven boom that fundamentally changed the way the world works.
A reversal of any of these factors could change the future economic and investing landscape. An investment portfolio that performs well in the decades ahead will need to be different from those in the past: Less reliance on beta (equities, credit and duration) to meet return targets. Increased allocation to diversifying alpha (risk driven asset allocation, alternative return capture). And a patient embrace of megatrends such as an aging population and the transition to a low-carbon world.