Over the past three years – well before the Covid-19 crisis – we have been arguing for a macro-financial regime shift, initially driven by the retreat of global trade as the main driver of global growth. The Covid-19 crisis has acted as a trend accelerator due to its de-globalisation footprint and implied supply-chain bottlenecks. Many growth engines have been re-shored, while the unified central bank model has ended.
We no longer envisage a synchronous global economic cycle. Rather, we may observe regional cycles and increasing fragmentation at a country level, suggesting country risk is back with a vengeance. More recently, the Russia-Ukraine war has reinforced the case for country divergences by adding geopolitical risk to the mix, and pushing inflation unevenly higher due to different impacts stemming from higher commodity prices and supply - demand mismatches. Different country exposures to inflation and, consequently, different room for action from central banks add to a fragmented puzzle.
Amid these exceptional transformations we believe now is a good time to look into long-term trends and lessons from the past in relation to absolute and relative returns – for both safe and risky assets – and regarding diversification benefits and traps. Our aim is to assess whether these trends may be confirmed or be challenged by the ongoing regime shift.
Looking at the past, we have already seen unexpected changes to well established correlation or return dynamics that have prompted investors to rethink their asset allocation approach. In 2008, during the Great Financial Crisis, investors thought they were diversified across asset classes but they were not as the majority of asset classes proved to be correlated during the turmoil. Hence asset class diversification brought little benefit during the worse of the crisis, when the only real diversifiers were safe-haven assets such as Treasuries and gold. Investors’ initial enthusiasm for factor-based allocation has resulted in some disappointment as unorthodox monetary policies have possibly weakened, at least temporarily, the power of factor diversification. More recently, traditional correlation metrics have started to break up in the face of inflation (e.g., equity/government bonds correlation turned positive) further questioning the traditional diversification framework.
The ongoing regime shift of high inflation will bring key implications for investors. With rising fragmentation and lower cross-country correlation, the benefits of global diversification is coming back in focus having been severely weakened by the effective correlation of global portfolios to the single factor of global trade.
Under such a fragmented scenario – featured by high and rising inflation – real returns will take centre stage, as investors look for sources of positive real returns and for exposure to assets that are correlated positively to inflation. Against such backdrop, we believe investors should revisit their strategic asset allocation framework and focus on three principles:
- Safe assets will prove less safe than was believed and will require investors to broaden their investment universe in the search for inflation protection. It’s time to reconsider the role of government bonds in asset allocation, as they will likely disappoint investors in the new regime and look for additional sources of real positive returns. Core allocations to government bonds should be reduced, investors should look for regional assets with the potential to deliver positive real returns as well as inflation linked securities.
- Global equities and real estate deserve a higher allocation and should see greater benefits from international diversification. Higher fragmentation of the economic cycle and the geopolitical reordering will drive up cross-country return dispersion after several decades of ‘sleeping integration’ driven by the high co-movement of global risk. Hence, in a world of low real returns for safe assets, investors should increase their allocation to risky assets, provided they enlarge their global perspective (including EM) and real assets.
- The correlation of safe assets versus risk assets is turning positive, as the inflation factor drives both asset classes. Hence, investors should consider structurally seeking to increase diversification by looking at real assets, gold, currencies and investment strategies that exhibit low correlation with equities and bonds.
The starting point for detecting what can be maintained from the past and what will likely change is an assessment of established long-term dynamics in terms of real returns and correlations. Building and developing on some assumptions from the work of Oscar Jordà et al. (who have estimated the real rate of return for everything from 1870-2015, with a focus on developed markets) we discuss the possible trends that should be maintained and sustained, as well as the aspects that should be revised as we should expect major looming changes.