Mid-Year Outlook: A global rewiring (full report) 

• Fragmentation has the potential to disrupt established performance trends across asset classes and geographies.
• After years of US exceptionalism, asset allocators must assess whether their geographic exposures remain appropriate.
• Evolving correlation patterns across asset classes demand a rethink of risk management and diversification processes.

Investors are facing uncertainty on multiple fronts: economic growth, fiscal policy, monetary policy, inflation, geopolitics, and international capital flows. Against this backdrop, asset class behaviours are fluctuating as macro dynamics shift, while certain traditional safe havens are becoming less reliable. Time-tested diversification techniques are therefore becoming less reliable, challenging investors’ ability to balance investment opportunity and risk.

Geographic allocation has become an area of concern, particularly for non-US investors, given the country’s elevated weighting in global indices. The high level of concentration that has developed within the US equity market as a result of tech dominance also requires further consideration, given shifting market dynamics.

The investment challenges – and solutions

There is a lot to digest, but we see a number of persistent market dynamics that can act as a guide for investor decision-making over the coming years, as illustrated below:  

Whatever an investor’s view, one thing is clear - what has worked in the past may no longer work in the future. Asset allocators should therefore approach their decisions with a forward-looking perspective, backing their strategies with in-depth research and recognising that asset class behaviours can change through time.

With that in mind, there are several actions worth considering:

1. Consider diversification across regions

Perhaps most obviously, global investors who believe that US market dominance has peaked (or even plateaued) should seek to increase the international diversification of their exposures. To achieve this, they might construct their portfolios using regional building blocks, improving flexibility to react to structural changes in the geopolitical backdrop as/when they reassess their regional exposures, including potential structural home biases versus global exposure. 

In equities, attractive bottom-up opportunities are being presented across Europe in markets like the Nordics and the UK. Across Asia, smaller companies look attractive, while China continues to offer compelling investments on an idiosyncratic basis. Emerging markets also look appealing, particularly opportunities in Latin America. In every case, selectivity will be important as investors assess structural exposures and tactical opportunities. Meanwhile, the dislocation of policy regimes around the world is likely to present opportunities across the credit spectrum at different points through the investment cycle, which can be captured through regional or active global aggregate strategies.

2. Capture future drivers of return

If we have entered a new era in which elevated uncertainty stifles growth, income could become a more important driver of overall returns. This will be especially true within equities if the mega-cap companies which have driven valuations higher see their exceptional earnings growth rates of recent years moderate.

Such risks support the use of dividend-based total return strategies focused on high-quality companies with pricing power, such as diversified equity income and enhanced income. Strategies which can offer all-in yields are attractive, such as diversified global fixed income or high yield.

3. Ensure portfolio flexibility

Increased volatility requires a broader and more flexible toolkit. Over the coming months, it will be critical to increase the precision of portfolio construction through a wider range of investment ideas, including actively managed strategies which can target more consistent investment outcomes. In equity allocations, this could mean taking exposure to specific styles or factors, such as quality or value.

For example, focusing on specific segments of the capitalisation spectrum, such as small or mid-cap companies, can help avoid concentration risks within the US market. Meanwhile, those who want to maintain exposure to the enduring technology theme might also consider a more value-orientated approach that can mitigate idiosyncratic risks associated with some of the mega-cap tech names. 

Beyond equities, portfolio optimisation can benefit from a more dynamic approach across a wider range of asset classes, including alternatives. This can include the use of diversified investment approaches within asset classes, for example active duration management within fixed income allocations.

4. Uncover uncorrelated sources of return

The necessity to preserve capital during periods of market turbulence supports a revitalised role for strategies that can deliver uncorrelated returns relative to equity and bond markets. In this regard, investors still have a broad toolkit of potential options at their disposal, including absolute return and market neutral strategies across asset classes, as well as contrarian, special situation, and multi asset options, which each have the ability to deliver differentiated returns. Private assets are also an increasingly important asset class for investors able to sacrifice liquidity.

5. Balance bonds differently

While there remains a role for Treasuries in portfolios within risk-off environments, recent bond and currency market turbulence might lead investors to diversify their geographic fixed income exposures and take a more flexible active approach across the capital structure. The context of each investor’s objectives and risks is key in such considerations, given the impact that variables like foreign exchange rates can have on overall portfolio risk and returns.

Bunds were a key beneficiary of recent volatility in treasury markets, a dynamic which endorses an increased role for unconstrained active strategic bond strategies. Finally, with cash rates still elevated, short duration and liquidity strategies can perform well at the lower end of the risk spectrum.