The ending of an era

Just as we have witnessed the ending of an era and the beginning of another with the passing of our beloved Queen Elizabeth II, investors should recognise that changing economic conditions and a new market regime are ushering in a new era of portfolio construction in regard to both equities and other assets – one which will see the decline of the conventional equity/bond portfolio.  This will involve a more imaginative approach to diversification and will be assisted by a number of opportunities across the asset spectrum, as well as by ensuring an adequate level of liquidity. Unprecedented times often require unconventional methods.

The challenges

Over the years this column has been critical of the poor economic and financial policies pursued by governments. Too much debt, money-printing and monetary growth, artificially low interest rates, and a huge tax-and-spend agenda, have not only resulted in a period of inflation, economic malaise and falling living standards for the majority – they have distorted financial markets to the point most asset prices (and the correlation between them) have increased. There will need to be some sort of reckoning. Most likely, either the valuations of financial assets and debt will be eroded by inflation over time or these values will have to decline and the debt unwound. The Goldilocks scenario is unlikely to play-out.

Low confidence in policymakers is not helping sentiment. Governments have been too complacent regarding inflation. As touched on in previous columns, central banks have ignored monetary growth figures going through the roof and clear evidence of pockets of inflation building. We were told inflation was not a problem. When it became a problem, we were told it was going to be transitory. When this was evidently not the case, we were assured inflation would shortly subside. Given the extent of such complacency, one would be forgiven for believing policymakers have kept interest rates artificially low so inflation could help erode the debt.

While geopolitics and the energy crisis have exacerbated the problem, it is governments that are primarily responsible for inflation. The markets also recognise that central banks are restricted in their policy responses given the extreme debt levels and scenario they’ve created. The preoccupation now is how far interest rates will have to rise. The US Federal Bank has finally admitted there will be some pain. However, while accepting we live in unusual times, it would be truly unusual to tame the current level of inflation with interest rates that remained substantially below that level. The current policy suggests a more severe economic slowdown than perhaps markets are expecting.

The remedy

At a time the country is still mourning the passing of Her late Majesty Queen Elizabeth II, after a lifetime of devoted service and inspiration to her people, and ushering in a new era under King Charles III, investors would be wise to embrace the new investment approach required to better accommodate this changed market landscape. This is particularly the case when seeking diversification. Just as portfolio construction has evolved over time to meet changing conditions, the thinking should again evolve given the conventional 60/40 equity/bond portfolio is typically using assets which are perhaps better suited to a previous market regime. And times have changed.

The markets have grown used to a period of relatively falling or stable inflation and low economic growth. This has tended to favour fixed-interest bonds over index-linked bonds and growth over value when it comes to equities. Such assets performed well in the last market regime but are unlikely to do so now.

Conventional bonds in particular remain vulnerable given the inflationary outlook, despite the many predictions and regulations of policymakers. As such, exposure to this asset class should be significantly reduced from conventional weightings. The only pockets of value are perhaps corporate bonds given current valuations, but even here one should tread carefully. And while protecting against inflation and against volatility can be two different things, index-linked bonds both home and abroad feature in our portfolios as markets (and central banks) may still be underestimating just how stubborn inflation will be.

As for equity holdings, broad market exposure by way of geography will continue to be important. However, we have long embraced the concept of thematic investing given the superior returns in prospect. Indeed, this concept now represents the larger component outside the UK in most portfolios. This is because sectors such as technology (especially smaller companies), healthcare, private equity and the environment will be continue to be among the secular long-term growth themes of the future regardless of any short-term volatility. And volatility should be capitalised upon to build positions for those underweight.

In addition, a growing component of investors’ general equity exposure will need to embrace a higher-conviction approach to stock picking if they are to thrive. Too many funds and institutional portfolios tend to hug the benchmark believing there is safety in numbers. This is becoming an increasingly dangerous fallacy. As Sir John Templeton reminded us, investors have to do something different if they are to beat the benchmark. Fund managers should increasingly do likewise.  And as the investment landscape continues to evolve, specialist investment trusts are superbly placed to capitalise given their structure better caters for the long-term investment needed when bucking short-term sentiment.

In addition to the different construction of a portfolio’s traditional bond and equity exposure, when compensating for the reduction in conventional bond exposure investors will need to be more creative when seeking other ‘uncorrelated’ assets. This is specially so given present policies are increasing the correlation between asset classes in general. For despite the new market regime, it remains a truism that it is usually wise to increasingly diversify a portfolio away from equities as the investment journey unfolds in order to help cushion the effect of any market falls. This investment discipline is particularly important to those near to achieving financial objectives.

These other ‘less-correlated’ assets presently include infrastructure companies – whose revenues have positive correlations of 0.7%-0.8% to inflation, environmental companies – which are benefitting not only from a favourable backdrop but also from increased power price forecasts, commodity companies – which are benefitting from higher mineral prices courtesy of the inflationary environment and geopolitics, along with companies within the specialist lending, capital preservation and commercial property sectors, together with gold. Many of these companies also offer decent levels of income and help portfolios achieve respectable yields relative to remit.

We are always seeking further assets which have an even lower correlation to the economy and markets. Hipgnosis Songs Fund (SONG) invests in songs and associated musical intellectual property rights, and receives revenue whenever they are played. This revenue has grown unabated, including during the pandemic. In July, the company reported a currency adjusted NAV of £1.548 which represented a discount of 27% when bought. A recent report from Goldman Sachs saw it upgrade its double-digit annual growth forecast to 2030. There may be some short-term volatility given the company’ debt is subject to rising interest rates, something it is addressing, but patient investors may be rewarded.

Another often unfashionable yet underestimated asset class is cash. It has its critics particularly during times of high inflation, but it is a known quantity when markets are volatile. Together with gold, history suggests it has been one of the best ‘diversifiers’ of all given its nature. It is also a ready reserve for attractive long-term opportunities given volatility will continue, including the pockets of value now appearing following the investment trust sector’s recent de-rating.

Disclaimer: The information contained in this article does not constitute investment advice or a personal recommendation.

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