So how do we devise a strategy? When we are dealing with events and trends which might be difficult to price, we try to step back and think about what aspects of the market we can be more certain about. This allows us to build more resilient portfolios.
What do I know for sure?
In recent years we have moved from a globalised world prone to deflationary shocks to a de-globalised, more geopolitically uncertain world prone to inflationary shocks. Against this backdrop, commodities and real assets provide diversification benefits while bonds are less effective shock absorbers.
We were already concerned that inflationary risk was underpriced because of the level of fiscal stimulus in the West. The conflict in Iran amplifies the inflation risk but the consequence for our view on government bonds is the same – we maintain a negative bias.
Credit spreads in the US are priced for perfection, not volatility. Yield-hungry investors continue to absorb elevated issuance, sustaining a finely balanced equilibrium, as hyperscalers fund the AI build-out. The expansion of private credit, as it has stepped into the shoes of the banks, adds opacity.
The labour market continues to be the key driver of central bank policy, particularly in the US. Although energy price spikes may cause inflationary pressure, the Federal Reserve is likely to lean dovish if the labour market weakens, particularly given uncertainty over the disruptive impact of AI. So, keep watching wage growth and jobless claims and don’t assume that this energy price shock will be followed by a rate shock.
Preparing for the unexpected
Instead of asking “what will happen next?”, investors should ask “how would my portfolio behave if something unexpected happens?”. At any moment market pricing represents a probability weighted range of scenarios. Thinking about the shape of that distribution can help to assess the likely correlation between asset classes and build more diversified and resilient portfolios.
Although equity market volatility is likely to increase given more expensive valuations, late cycle dynamics and geopolitical uncertainty, structurally higher nominal growth driven by government spending and technological innovation provides opportunities. Equities remain a great inflation-busting asset class.
In my 30-year investment career, there hasn’t been one day where investing felt easy. Our job is to manage risk and uncertainty. When confronting different risks every day, investment processes establish accountability and a shared language. They build an approach which eliminates coordination uncertainty in the face of volatile and emotional markets.
Resilience is a team game and so we must ensure that our investment teams are stable and cohesive so that we may manage our psychology as we navigate troubled waters.
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