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Magazine Issues » November 2022

Alfi Conference: The equity/bond mix matters more in the years ahead

MarketsMarkets are in a fundamentally different landscape to the period that followed the global financial crisis. Two senior professionals discuss asset allocation – and the energy transition could help, as Nick Fitzpatrick reports.

Pension funds will have to take a close look at their equity/bond mix now that markets and economies are entering a period of higher inflation, a conference featuring two investment strategists from top asset management firms heard.

Returns from classic 60/40 mixes – whereby investors would hold 60% in equities and hold the balance in bonds – were “not that different” to returns from 40/60 mixes in the past.

“But that mix matters now,” said Wei Li, global chief investment strategist at fund manager BlackRock.

Li was discussing investment and product strategy with Johanna Kyrklund, co-head of investment and group chief investment officer at Schroders, at a recent London conference hosted by the Luxembourg funds industry association, Alfi.

In a discussion entitled ‘End of the second belle époque’, Li said that a “regime change” is taking place. We are moving from a period in which demand led economic progress from the 1980s to the Covid-19 pandemic, to one that started recently in which supply factors will dictate economic cycles.

“We estimate that the equity/bond mix matters four times more in the decades we are entering than in the decades that we’ve left behind.”

Put another way, the previous period was characterised by “steadily growing production cycles”, said Li, but this low-cost, low-rate environment is “going in the other direction” today, with higher rates to try to stem higher prices.

“We estimate that the equity/bond mix matters four times more in the decades we are entering than in the decades that we’ve left behind,” she added.

Kyrklund of Schroders said that defined benefit (DB) pension plans would probably find they cannot take as much risk on growth assets when central banks are dealing with inflation and financial stability simultaneously. Deleveraging by DB plans could lead to lower levels of investment in illiquid assets.

During the pandemic, markets became used to government intervention, “even telling us how many people we could have in our house!”, said Kyrklund.

Flexibility on energy
Much of the volatility present in markets today is down to investors trying to recalibrate the ‘new normal’ as the world moves from one where zero interest rates were evenly applied across major economies to one where there will likely be more divergence in monetary policy across regions.

Yet both of the investment strategists highlighted green finance’s role in the decades to come.

BlackRock’s Li said pre-positioning for net zero could help investors, while Kyrklund said the energy transition would help in guiding investors through the adjustment ahead of them.

“I think thematically the commitment to net zero will play out for a long time to come,” said Kyrklund, adding that the “invisible hand of the markets” – the metaphor for how self-interest by market participants plays a role in correcting markets – will not be enough; we need a more “inclusive growth”.

Kyrklund added that although there will be a need for more flexibility on energy sources in the shorter term, the energy transition will intensify over the medium term as nations seek greater energy security. She said the need for sustainable food and water sources would also increase.

Li agreed, saying there was a “dire need” for an energy transition. She said investment portfolios would likely consist of some traditional energy names but those that have credible energy transition plans.

For now, BlackRock is forecasting recession in the UK and Europe this year and in the US next year, driven by central banks using rate-tightening to fight inflation.

In this environment, Li said government bonds would historically be a typical diversifier. But her preference now is for short-duration investment-grade corporates. “Rates can go up quite a bit before this part of the market becomes less profitable.”

“I think thematically the commitment to net zero will play out for a long time to come.”

Shorter-term government bonds are also in favour, but high-yield bonds and developed market equities are not. The SP 500 would have to see a 7% sell-off for her stance on equities to rise to neutral because, at that point, the “bad news” would be priced in.

Kyrklund highlighted commodities had a place to play in a portfolio mix, being “quite helpful” now in a way they were not in the past decade by hedging against inflation.

Due to volatility, Li joked that her thinking on this may have changed a week later. Similarly, Kyrklund said she felt better now than at the beginning of the year due to the “massive correction” that has taken place.

Both women emphasised the difference in the market and economic environment now compared with the years after the global financial crisis (GFC) that started in 2008 with the collapse of Lehman Brothers and the mortgage market.

Li said the world is in a “fundamentally different” environment now compared to 2008. A critical difference is that back then, there was a “balance sheet recession”, unlike now, where corporate balance sheets are stronger. Crucially, this applies to banks and asset managers.

Kyrklund said that Schroders’ “bottom-up stock-pickers” were very positive about banks, where levels of liability risk are lower in the sector than before the GFC.

She added that despite the shock presented to DB plans with liability-driven investment (LDI) strategies recently, risk taken by asset managers was limited and that the industry’s main challenges were fees and consolidation in the emerging environment.

“Everything problems”
Postscript: Following the discussion, Helen Thompson, professor of political economy at Cambridge University, presented evidence that oil-supply constraints predated the recent invasion of Ukraine and stretched back to 2005, with a pernicious effect on growth. This includes, of course, the timeline post the 2008 crisis, which was characterised partly by slow growth.

The professor argued this would not change without a radical shift away from oil. Without that, “energy problems would become everything problems”, she said.

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