As inflation runs hot and interest in ESG impacts rises, there is a fundamental shift in our institutional and sub-advisory clients’ needs. We expect allocations to alternative risk assets, and to assets with positive environmental impacts, to increase.
Just as was the case in 2020 and early 2021, investors are
continuing to broaden their portfolios into alternative asset
classes. What is different now is the economic backdrop.
At the end of 2021, major economies such as the United
States and the United Kingdom reported the highest inflation
levels for more than 10 years. Bond yields remain historically
low despite rising since the beginning of 2022, and central
bank interest rate rises are coming, even if the inflation spike
eventually proves transitory. This means portfolios need to
build a stronger link to inflation through risk assets, as the
outlook for bonds is not so favourable.
As greater instability in inflation and interest rates tends to
trigger higher currency volatility, we have been looking at how
currencies should be hedged. The old dictum of hedging your
bond currency exposure but leaving equities unhedged does
not work in a diversified portfolio. In times when inflation
and interest rates are racing away, it is important to hedge
currency in an informed and clever way. But how to do so
depends on whether you’re a dollar or non-dollar investor.
For a sterling or a euro investor, US dollars can look very
attractive because they are the go-to asset in a crisis.
Dollar-based investors, by contrast, should typically hedge away overseas
currency risks. There is also the issue of how yield curves are moving, with
the US evidently further ahead when it comes to rate rises than the EU.
The strengthening case for alternative investments
When it comes to diversification, investors have lifted their allocations
to alternative asset classes, even at a time when public markets have
been performing very strongly. The logic of diversifying into infrastructure,
private credit and private equity remains strong because they add stability
to portfolio returns. They are especially relevant for longer-term portfolios
such as defined contribution schemes – as the thinking matures around
how these pension schemes approach risk, so allocations to alternative
assets are likely to rise. Indeed, the Netherlands’ introduction of collective
defined contribution schemes is likely to favour higher allocations to risk
assets and more illiquid investments, not least to private markets.
Going ‘green’: from exclusion to ESG
Investors are quickly shifting their approach from primarily excluding
assets that are not green to actively investing in businesses that will
have a long-term positive impact on the environment, for instance
through better use of plastics or developing green hydrogen as a source
of power. For investors such as insurers, ESG (environmental, social
and governance) is becoming a portfolio’s fourth pillar alongside risk,
return and capital. This influences how you select the building blocks of
portfolios, and we have been doing a lot of research into what we call
“green capital market assumptions”.
Conclusion
The outlook for inflation and interest rates will be very important in 2022.
What will they mean for the role that fixed income plays in portfolios?
This is a question every investor must ask. There are also implications
for alternative assets and currencies. Despite their disappointing
performance, alternatives will have an increasingly important role as
stabilisers in long-term portfolios. With currencies, high inflation – whether
transitory or not – means investors must be clear about what exposure
they have and why. Finally, 2022 will be a year when ESG impacts become
a key dimension of portfolios for many investors, alongside risk and return.
