Asset allocation and investing in a changing world

Favourable past conditions, and an uncertain future

The investment environment over the last four decades has been shaped by a number of widely discussed trends, the combination of which made the investment environment favourable for investors.

A mix of declining interest rates and increasing levels of public debt have, until recently, provided a cushion for investors and helped policy makers mitigate the impact of business cycles and financial crises. At the same time, corporate tax rates have trended downwards, facilitating increasing payouts to equity holders.

In addition, cross-border trade and finance grew increasingly globalised, which brought growth opportunities to companies in the West as they expanded around the world. Investors have been operating within a US-centric global financial system, built around the US dollar as a key reserve currency, and underwritten by US military strength and global presence.

These trends translated into favourable outcomes for investors in the form of a long series of positive shocks to earnings/dividend growth for equities and similarly a series of lower-than-expected inflation and real interest rate outcomes, all of which have supported returns across asset classes. As a result, investors achieved significantly higher returns than they would have otherwise.

It is increasingly clear that many of the trends that were tailwinds for investors in past decades cannot continue and in some cases have already started reversing (e.g. real interest rates). For example, the sustainability of government debt in many developed countries is increasingly a concern for investors, and the capacity for fiscal stimulus looks likely to be constrained relative to the past.

At the same time, the recent policies of the new US administration have the potential to accelerate and facilitate reversals in certain trends, drastically redirecting the flows of goods, services and capital. These changes have the potential to alter the role of the US financial system and the US dollar in the global economy.

Significant macro uncertainty, and a lack of tools for investors

Looking ahead, the general theme is one of growing long-term uncertainty around fundamental issues in global (geo)politics, economics, and markets. Asset allocators and investors need to grapple with fundamental questions that they were not forced to address before:

• What are the implications of changes in US international policy stance for safe assets? Will currencies behave differently going forward?
• What are the implications of the geopolitical shifts for different asset classes and regions?
• Is US exceptionalism over and will high US asset valuations suffer?
• How will high levels of government debt be reduced and what does this mean for bond investors?
• What is the secular outlook for private capital and digital assets?
• What is the impact of rapid advances in Artificial Intelligence on the global economy and markets?
• What do trajectories of climate change and net zero policies imply for global investors?

These questions receive plenty of attention from market strategists and financial press, but concrete guidance for asset allocation is often missing. Discussions usually focus on a narrow view: dissecting a particular event/asset class e.g., noting unusual co-movement of the dollar and equities, or raising broad concerns about how we are likely going through changing market regimes. Investors and asset allocators are inundated with research notes and chart packs providing colour on big issues. It remains difficult, however, to discern exactly what to do about these questions when devising asset allocations.

Popular asset allocation tools are also lacking when faced with the prospect of changing macro regimes. One issue is the overreliance on historical data, which implicitly assumes that the trends we have witnessed in the past decades will continue. This approach leads to too narrow a set of possible macro and investment outcomes, and thus underestimates risk. Most models and frameworks have been developed and estimated in one particular macro regime, and overly focus on the US experience - and thus are not well-placed for responding to significant macro changes.

We think that the only way to make progress on this front is to use a macro-finance framework that can provide a comprehensive and quantitative basis for tackling these big questions.

How can investors deal with macro uncertainty?

The transition to new arrangements of international engagement will inevitably take time and produce twists and turns for investors that are hard to anticipate today. During this period, macro and financial markets might be volatile, and asset prices might move sideways for extended periods of time. It might still be that we end up in a similar place to where we started, and with US role in the world strengthened – we cannot know in advance. It is important to stress that there is not only uncertainty around the current US administration and their tariff policies, but also around many structural trends to which policy makers and politicians can only react and influence to a limited extent.

We think investors need new and robust allocation frameworks that can help them systematically assess the behaviour of assets and portfolios across scenarios and their risk-return profiles. Instead of allocating effort and resources to making predictions about ‘correct answers’ to the questions posed above, it is more productive to invest in building and exploring scenarios, and incorporating their implications into portfolios.

For example, predicting and preparing for the retreat of the US dollar as a reserve currency is a misguided approach to adjusting asset allocations. Instead, we think investors need to model alternative futures of the international monetary system, which assets would play roles as safe assets, and how other assets would react in each scenario. This provides a more robust basis for preparing portfolios for the future. In addition, the safe asset question is closely related to questions around US exceptionalism, and what happens with the US government debt – we need frameworks for thinking through scenarios that can address these questions jointly.

Our preferred framework uses macro drivers of asset prices as building blocks for designing scenarios. These scenarios can cover a wide range of changes in political/economic/investment landscapes. The starting point matters greatly for scenarios, and the first step is to know what is priced into each asset class across horizons. For example, today’s starting point for US equities is characterized by low equity risk premiums and a relatively high equity duration, which means that equity investors should expect to earn relatively low real returns relative to government bonds and prepare for larger swings if the long-term expectations start to move in either direction.

Relating policies, secular trends, geopolitics etc. to macro drivers in the form of macro risk factors preserves the economic structure and imposes discipline on analysis. Through understanding the macro risk factor exposures of different assets, we can also model the performance of a wide range of assets in different macro scenarios and returns over different horizons. This puts us in a position to make sense of the uncertainty and complex interactions that are embedded in big macro questions, and to focus our efforts on important dimensions of these problems. For example, a lot of time is spent discussing the sign of the equity-bond correlation. Even if the correlation is negative for short-term returns, common macro drivers lead to positive correlations for long-horizon returns (we will expand on this in an upcoming Insights article).

Building portfolios in a changing world

If investors can access quantitative scenarios, with an understanding of how a diverse set of assets might be more or less adversely affected in each scenario, we move closer to designing more balanced portfolios as the world changes. To build these portfolios, we need to add expected returns and simulation modelling into the mix. An asset that gets consistently referenced for its protective properties is Gold. It could be the case that Gold ranks near the top of the list of assets that performs relatively well across many adverse macro scenarios (especially related to inflation and real interest rates). The issue, of course, is that this is likely to be reflected in gold prices and expected returns. If there is broad-based demand for insurance and all investors are worried about the same set of risks, the market can reprice to a higher premium. This certainly fits with recent market moves. As investors have confronted macro uncertainty in recent months, Gold prices have been reaching all-time highs.

When it comes to asset allocation, investors may well want macro insurance, but they need to consider the price (expected return) for this insurance too. Investors can explore other assets in addition to Gold that can add to portfolio resilience. Financial assets have different exposures to macro factors such as inflation, rates, growth, and across regions. It is key to establish how the range of alternatives (privates, hedge funds, crypto etc.) being pitched as go-to assets in a changing environment specifically impact portfolios. They can be combined in such a way that adds to portfolio resilience, where each asset has a different price/expected return attached to its risk profile.

In addition to expected returns, simulation models are an important asset allocation tools. Investors vary in terms of the cyclicality and currency of their liabilities, outside income sources, constraints, risk tolerance, and more. Risk is therefore unique to each investor, and the risk-bearing capacity and the desire to insure against certain adverse investment outcomes will differ across investors. To the extent that risk in asset markets has changed, this will be reflected in the properties of both assets and liabilities of investors, and these need to be evaluated together. This all adds an additional layer of complexity to asset allocation analysis that is best tackled by explicit modelling of investors alongside asset markets. Joint modelling of asset markets and objectives/liabilities allows investors to precisely identify bad outcomes they would like to insure against and also find the right asset mix to do so.

To make sense of all of this, we need asset allocation tools fit for the moment. Our set of macro-finance asset allocation tools help investors to move forward in adapting their portfolios in a new era of macro uncertainty.