From stability to agility: nine implications for a new investment landscape

Broaden diversification and implement a more detailed correlation analysis for enhanced resilience, Nuveen suggests

Post-Great Moderation, institutional investors face a new landscape, and the principles guiding past strategies need reassessment. Heightened macroeconomic and geopolitical uncertainties necessitate a robust approach to diversification and risk management. Fiscal and monetary policy dynamics are changing, as are international relations, with a shift towards national security and self-reliance over global economic growth. Despite consensus on the need for change, there is no agreement on the asset classes and diversification strategies for this new order. As such, we have identified nine themes for investors to consider for portfolio resilience in this unpredictable landscape. While nearly half of institutional investors in a recent Nuveen survey aim to improve flexibility and adjust regional allocations, many overlook strategies for enhanced resilience, such as broadening diversification and implementing a more detailed correlation analysis.

The Great Moderation's low uncertainty and interest rates favored higher asset prices. However, the pandemic ended this era. Central banks and governments' coordinated stimulus efforts to counter the economic fallout have led to the ripple effects being mitigated. This large-scale fiscal and monetary intervention has ushered in a post-moderation era, marked by increased GDP growth and inflation volatility, and a disrupted relationship between interest rates and the real economy. Greater economic volatility is likely to result in higher capital markets volatility and interest rates, and investors should be cautious with forecasts based on Great Moderation conditions. The post-moderation era will likely require a shift in investment strategies, with strategies that underperformed during the era of loose money likely playing a more constructive role in diversified portfolios.

Investors are increasingly aware of geopolitics growing role in risk assessment. Conflicts and information wars, particularly between the US and China, have heightened uncertainty amidst de-globalisation trends. The current geopolitical landscape will favor some countries while challenging others, likely causing a wider dispersion of market returns, and the peace dividend is dwindling as nations prioritise national security and self-sufficiency over collaborative economic growth. From a portfolio perspective, global market capitalisation-weighted indices may not be optimal for geographic diversification. Instead, investors could better structure their geographic allocations by focusing on the economic forces influencing market risks and returns. This approach, distinguishing between a country's economy and its capital markets, allows for a direct link between allocations and portfolio objectives, and incorporating geopolitical factors will further refine allocations.

Inflation, though a concern, is not investors' main concern anymore. The percentage planning to increase inflation risk-mitigation strategies fell from 64% in 2022 to 41% in 2023, indicating portfolio adjustments, optimism about central banks' inflation control, or recency bias. The belief in monetary policy's ability to manage inflation remains, but investors should remember that long-term inflation is not solely a central bank function. We have identified four structural trends - de-globalisation, energy transition, aging demographics, and deficit spending – that will challenge central banks' low inflation targets.

Investors often focus on stocks of AI development companies, but a broader perspective is needed. AI's disruptive potential and its impact on growth, inflation, and labor dynamics are extensive. Although technological innovation boosts growth, AI's impact will be uneven, with some sectors cannibalised and new ones emerging. Different countries will benefit based on their economic composition, and solely investing in AI software manufacturers may overlook opportunities. AI's productivity gains could stimulate growth and counteract inflation, similar to the Internet boom. Increased productivity typically corresponds with higher real interest rates, but as productivity growth expands the labor supply, it exerts less upward pressure on nominal rates. Despite AI's potential, investors should not assume it will offset all inflationary factors as AI growth requires substantial computing power and resources and may divert highly skilled labor from other sectors.

In the recent Nuveen survey, 50% of respondents plan to increase portfolio duration to leverage higher rates, while 19% plan to decrease. Improved funding ratios have led some, particularly corporate pension and insurance-based respondents, to de-risk and better match liabilities. Those adding government bond exposure should scrutinise their long-term prospects. Government bonds, once a 'unicorn asset' during the Great Moderation, may now be viewed more as risk assets than diversifiers in the post-moderation environment as they are not immune to interest rate risk, despite being largely free from default risk. The 2023 liquidity call highlighted that government bonds are not risk-free. Higher structural inflation could lead to positive stock-bond return correlations, and investors seeking diversification may find value beyond government bonds in this new era.

Previously, institutions struggled to find high-yield assets due to negligible or negative risk-free rates. This low-return environment forced investors to assume high risks. However, the reset of the risk-free rate now allows a wider range of asset classes to achieve targeted returns. Despite this, most equity valuations are inflated, and credit spreads are tight. Total expected returns seem attractive, but their appeal comes from the higher risk-free rate, not an increase in the equity risk premium or credit spreads. Investors no longer need to take high risks to meet return needs. The current environment calls for a nuanced approach to diversification, risk management, and dynamic strategic asset allocation, and analysing portfolio risk exposures is crucial. Some investors may find their risk exposures less diverse than expected or not adequately compensated for the risks they bear.

The shift towards private investments is growing, with 55% of respondents planning to increase their allocations in the next five years. This highlights the need for discerning investment in private markets. Investors should remember: 1) product wrappers do not define risk or exposure; 2) private assets do not automatically diversify a portfolio; and 3) avoid duplicating risk or return factors as some private market exposures are publicly accessible. Allocating to unique private assets, like royalty portfolios or farmland, can optimise a portfolio's illiquidity. Private markets can be used for value extraction from deal sourcing, operational improvements, and structuring expertise, and investors may find more value focusing on these aspects rather than the often-cited, hard-to-estimate illiquidity premium, or volatility-suppression, which is more a reporting construct than a risk reflection.

Real assets like commodities, farmland, timberland, and infrastructure are often discussed for their ability to manage inflation risk. Some hedge short-term inflation spikes, while others yield positive real returns over time. They enhance portfolios by offering attractive returns in scenarios detrimental to financialised assets like stocks and bonds, due to their inherent scarcity. For example, timber growth is limited, farmland is finite, and oil extraction requires unique skills. In contrast, financialised assets can be produced quickly and cheaply. Asset prices result from supply and demand interplay, and while supply dynamics differ between real and financialised assets, demand is driven by economic growth. Investors can leverage real assets to focus on long-term growth drivers, such as infrastructure, land, and commodities needed for AI growth. The value of real assets is driven by idiosyncratic risk factors and supply limitations, enabling them to retain their diversification benefits in a post-moderation world.

The active versus passive management debate in equities and other asset classes continues. While skilled active investors can enhance portfolios, asset allocation is the primary driver of a diversified portfolio's outcome. Most long-term investors use static asset allocations. However, in a post-moderation world with increased macro variability, a dynamic approach to strategic asset allocation, along with tactical allocations and security selection, is likely to boost portfolio resilience. A 'set-and-forget' approach may not thrive in this environment. Changing risks and returns, driven by macro factors, require more dynamism in strategic asset allocation. Without it, the portfolio's risk posture becomes a byproduct of market dynamics, and investors lose their ability to link the portfolio to their desired outcome. Despite this, many investors are staying the course. While nearly half agree that market fundamentals have changed and are recalculating their capital market assumptions, less than a quarter are making foundational changes to their asset allocations.

The post-great moderation era demands a fresh approach to investing, and institutional investors must rethink traditional strategies, emphasising greater diversification and dynamic asset allocation to manage evolving country-specific risks. We believe that real assets should take a central role due to their inflation resilience and unique risk exposures, and geopolitical factors are now crucial, requiring a shift from global cap-weighted allocations. Strategic flexibility and nuanced risk management are also essential for building resilient portfolios in this uncertain economic environment, and adapting to these changes is vital to effectively navigate the complexities of the new regime moving forward.