A blueprint for thriving in a changing world

Key takeaways

• A successful approach to portfolio allocation should address investors’ total wealth holdings, combining liquid and private assets
• Higher expected returns in the decade ahead, particularly for fixed income, call for simpler portfolios with fewer non-core exposures. We have revised our strategic asset allocation (SAA) to reflect this
• We are strategically positioning portfolios by increasing core equity exposures, including US equities, and in certain profiles raising bond allocations. In the context of a total wealth approach, private assets, including equity, debt, infrastructure and real estate, can add diversification and returns
• After multiple shocks, the global economy has shifted. Governments have more appetite for fiscal spending while trade and investment flows fragment, arguing for higher average inflation over the next decade.

A higher-rate environment means higher expected investment returns for fixed income in the coming years. This means proportionately less risk is needed to achieve equivalent returns and argues for simpler portfolios that take into account investors’ total wealth. Portfolios will focus on core regions and exposures, as well as harnessing the potential returns available through private assets where appropriate.

Investments, and investors, must adapt to an ever-changing world, and in this case, one with a higher ‘risk-free’ rate and higher average inflation versus the pre-pandemic environment. Importantly, this must be done in a holistic manner, taking advantage of the opportunities available in both traditional liquid asset classes, as well as private assets through a total wealth approach. We have adjusted portfolios strategically to reflect this new reality and build on this solid foundation through tactical decisions designed to take advantage of short-term market opportunities, as we strive to preserve and grow our clients’ wealth.

An holistic, total wealth perspective

Private assets are an integral part of our strategic asset allocation. While liquid assets form part of every asset allocation, private equity, private debt, infrastructure and real estate, can offer significant portfolio diversification and return advantages, albeit in exchange for lower liquidity. In relative return terms, private equity should retain an edge over public markets. Hedge funds also belong in a well-diversified strategic asset allocation, as such strategies should outperform cash, and add value, but here manager selection remains key given wide dispersion between different funds’ performance.

In liquid assets, higher rates have made bonds more attractive. We have therefore raised our strategic allocation to fixed income in more risk-averse client profiles – conversely lowering equity exposures – and extended bonds’ duration across portfolio risk profiles in anticipation of falling interest rates. Government debt now offers a higher return for lower risk than other asset classes. In particular, US Treasury returns should outperform cash and act once again as a diversification tool in portfolios as inflation normalises, after a string of negative yearly returns.

Elsewhere in fixed income, investment grade credit in developed markets offers attractive yields and resilience, as low refinancing needs and less-leveraged balance sheets offset higher borrowing costs for companies. High yield credit is also likely to see more attractive, equity-like returns in the years ahead. We are therefore slightly increasing exposures to these segments in some profiles and are removing standalone allocations to emerging market debt in local currency, Chinese debt and convertible bonds across all portfolios.

Looking forward, the balance of expected returns between fixed income and equities has shifted. The equity risk premium versus bonds has fallen, and is below historical averages, arguing for increased portfolio exposure to rates and spreads.

Equities remain a core portfolio holding

That said, equities remain a core portfolio holding. They give investors access to the long-term economic growth and profitability of companies, and their expected returns over the coming decade are broadly stable on previous years; at 7.6% they are still ahead of most fixed income returns. Our overall equity holdings across balanced and growth profiles remain the same.

Equity returns are, and will continue to be, mostly driven by earnings growth. However, the last decade of exceptional corporate profits will be hard to repeat since they were boosted by declining interest rate expenses and lower corporate tax rates. We expect corporate margins to partially normalise but remain above historical averages.

We have adapted our regional equity allocations to reflect a greater US market weighting across all portfolio profiles. This underlines our conviction that US markets should, over time, continue to outperform the rest of the world. In addition, we want to reflect some home-market equity preferences, depending on clients’ profiles. To balance this, weightings to other regions will be reduced, in particular those to emerging markets and China. These simplifications help to remove the need for currency hedges for most clients.

Why the path to higher rates will lead to lower rates

Let’s now turn to the macroeconomic outlook underlying this portfolio structure. We see signs that post-pandemic, a series of key variables have shifted in the global economy. After a subdued response to the Great Financial Crisis in 2008-2009, Covid triggered a greater government appetite to accelerate economic recovery, facilitating a faster rebound than historically seen after crises. Governments look more likely to support their economies in future downturns and are more accepting of fiscal deficits to meet higher investment needs in sectors ranging from defence spending to the climate transition. More recently, we also see indications that productivity growth may increase, especially if artificial intelligence delivers on its promised dividends.

This fiscal largesse, and the fragmentation of global trade and supply chains, also contributes to structurally higher inflation. Global competition will likely continue or intensify. The US is serious about de-risking from China, and the West more broadly is looking to offset Chinese imports through other suppliers, including those in emerging markets. That in turn creates a boom in capital expenditure, including the return of strategic industries to home markets. Meanwhile, job markets are tight and service-driven economies have become less rate-sensitive, which is one factor behind the US economy’s remarkable performance to date.

Long-term demographic trends, such as rising longevity, have also pushed up savings, as has increasing income inequality in many nations. Meanwhile, an ageing workforce also argues for lower growth, a problem that China faces for the first time in the decade ahead.