Embracing volatility

Having just ticked over the half-way mark of the year, a cursory glance at portfolios shows multi-asset investors have so far been rewarded with strong returns in 2024.

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Equity markets have risen strongly; driven by market momentum, solid earnings growth, and overwhelming enthusiasm for AI.

"Global markets are being rapidly transformed by numerous structural trends including disruptive technology, global demographics, and the green energy transition."

These gains have come despite a significant recalibration of interest rate expectations, particularly over the early part of the year. Nonetheless, the sharp decline in yields over the past two months has also seen fixed income assets provide solid returns to portfolios.

As investors though, dwelling too long on past performance is not typically a valuable use of one’s time. While we look ahead to the rest of the year our eyes are also set on a horizon in which significant structural changes will create volatility – but also bring opportunity.

Evolving landscape

As we have been discussing with clients for some time now, global markets are being rapidly transformed by numerous structural trends including disruptive technology, global demographics, and the green energy transition.

Amongst other contributing factors, these trends appear to be leading to divergent ideologies, increasing nationalism and a multi-polar world. In response to this change, governments are increasingly adopting expansive fiscal policies — accumulating burgeoning debt in the process.

We expect these conditions to ultimately result in more sustained periods of upwards sloping inflation, structurally higher interest rates and higher volatility. Of course, the one caveat to this outlook is technology, and the productivity benefits it may bring.

Nonetheless, for investors, these changing macroeconomic conditions may cause asset class correlations — some that have underpinned portfolio construction for the past 20 years — to break down more regularly, as traditional drivers of asset prices, including interest rates, are overwhelmed by the alternative policy measures being deployed by officials in response to an increasing number of exogenous shocks.

Once reliable correlations may turn positive on a more frequent basis

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Source: S&P Global, U.S. Treasury, Macrobond, ANZ CIO

While this outlook may sound concerning for some investors, we believe it also offers opportunities for those willing to adopt a more nuanced, tactical, and long-term approach to investing.

As such, our recently completed strategic asset allocation review has seen us make several adjustments to prepare portfolios for this new investment paradigm.

Embracing the new paradigm

Firstly, given the potential for more volatile markets, we have doubled our allocation to alternative assets, implemented via a combination of alternative-risk premia and hedge funds. This is predicated on providing a more consistent risk-adjusted return stream to portfolios throughout any market environment.

Secondly, rising protectionism, the shift to a multi-polar world and the potential for structurally higher inflation, has seen us implement a new strategic allocation to gold within portfolios.

Thirdly, while most of the emerging market universe should benefit from a demographic dividend in the decade ahead, developed markets are facing demographic headwinds that we believe may contribute to a more challenging return outlook for developed market equities. As a result, we have modestly increased our strategic exposure to emerging market equities at the expense of developed market shares.

Finally, we have adopted a more nuanced approach to fixed income; collapsing Australian and global fixed income allocations into long and short duration fixed income to provide a more efficient means of matching the required level of duration to an investor’s risk profile. This change will see a higher allocation to short duration for lower-risk profiles, providing capital stability in a range of market environments, while more aggressive profiles will have a greater allocation to long duration as a hedge against higher equity allocations.

Diminishing talk of recession

Alongside these strategic changes, we continue to make tactical adjustments to portfolios, reflecting our shorter-term market view.

Talk of recession has diminished appreciably this year. Indeed, markets are now pricing only a 5-to-10 per cent chance of recession in the US. And with recent US inflation data reopening the door for rate cuts from as early as September, the possibility of a soft landing remains our base case.

Nonetheless, the term spread between US 10-year and 3-month Treasury yields suggests the risk of recession over the next 12 months sits closer to 50 per cent. And with yields on risk-free assets still elevated by historical standards, and valuations across some pockets of the equity market stretched by comparison, we remain defensively positioned across portfolios.

Following the strong equity market rally over the first half of the year, the potential upside for equities and bonds looks evenly balanced. However, with yields at current levels, equities have a more asymmetric risk profile, and we favour fixed income as a result.

Within this segment of portfolios, we hold a modest underweight to short duration assets, where yields are currently commensurate with cash rates, instead overweighting long duration bonds as a hedge against recession risks.

Of course, the yield curve — which has remained inverted for almost two years — has not been a reliable tool for predicting recession more recently. And with liquidity likely to remain abundant heading into the US election, we have allowed our overall equity exposure to drift modestly above benchmark, the position balanced by tactical additions to duration over the past quarter.

Equity markets

Within equities, we hold a modest overweight to developed market shares, partially offset by a similar underweight to emerging market and Australian shares. In the case of the latter, although valuations remain attractive, we believe the outlook for domestic earnings may be challenged by a weakening global growth impulse and a central bank that appears unlikely to cut interest rates until 2025.

Across developed markets, we continue to prefer the outlook for European shares and are closely assessing Japanese equites. Stabilisation of the yen or a sustained period of underperformance from the Japanese share market could be catalysts to increase our positioning.

Across our diversifying assets, we are positioned at benchmark to listed real assets and alternatives and hold a significant underweight to high yield credit.

In the case of gold, while price levels have recently receded from all-time highs, they remain elevated despite strong real yields and US dollar exceptionalism. Indeed, the precious metal remains well supported by other structural factors including a push by some emerging economies to reduce their dependency on the US dollar.

Given the prevailing geopolitical risks, and potential for these to escalate ahead of the US election in November, we are positioned with a mild overweight to gold across portfolios.

So, while we keep one eye firmly focused on the remaining six months of the year, the other will be fixed on the evolving global landscape and how best to structure portfolios to navigate what we expect will be an increasingly volatile decade ahead.

Lakshman Anantakrishnan is the Chief Investment Officer at ANZ Private.

This is a version of a piece first published on ANZ Private Insights.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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