investment insights

    A blueprint for thriving in a changing world

    A blueprint for thriving in a changing world
    Michael Strobaek - Global CIO Private Bank

    Michael Strobaek

    Global CIO Private Bank
    Christian Abuide - Head of Asset Allocation

    Christian Abuide

    Head of Asset Allocation
    Paul Besanger - Portfolio Manager

    Paul Besanger

    Portfolio Manager

    Key takeaways

    • A successful approach to portfolio allocation should address investors’ total wealth holdings, combining liquid and private assets
    • Higher expected returns in the decade ahead, particularly for fixed income, call for simpler portfolios with fewer non-core exposures. We have revised our strategic asset allocation (SAA) to reflect this
    • We are strategically positioning portfolios by increasing core equity exposures, including US equities, and in certain profiles raising bond allocations. In the context of a total wealth approach, private assets, including equity, debt, infrastructure and real estate, can add diversification and returns
    • After multiple shocks, the global economy has shifted. Governments have more appetite for fiscal spending while trade and investment flows fragment, arguing for higher average inflation over the next decade.

    A higher-rate environment means higher expected investment returns for fixed income in the coming years. This means proportionately less risk is needed to achieve equivalent returns and argues for simpler portfolios that take into account investors’ total wealth. Portfolios will focus on core regions and exposures, as well as harnessing the potential returns available through private assets where appropriate.

    Investments, and investors, must adapt to an ever-changing world, and in this case, one with a higher ‘risk-free’ rate and higher average inflation versus the pre-pandemic environment. Importantly, this must be done in a holistic manner, taking advantage of the opportunities available in both traditional liquid asset classes, as well as private assets through a total wealth approach. We have adjusted portfolios strategically to reflect this new reality and build on this solid foundation through tactical decisions designed to take advantage of short-term market opportunities, as we strive to preserve and grow our clients’ wealth.


    An holistic, total wealth perspective

    Private assets are an integral part of our strategic asset allocation. While liquid assets form part of every asset allocation, private equity, private debt, infrastructure and real estate, can offer significant portfolio diversification and return advantages, albeit in exchange for lower liquidity. In relative return terms, private equity should retain an edge over public markets. Hedge funds also belong in a well-diversified strategic asset allocation, as such strategies should outperform cash, and add value, but here manager selection remains key given wide dispersion between different funds’ performance.

    The balance of expected returns between fixed income and equities has shifted

    In liquid assets, higher rates have made bonds more attractive. We have therefore raised our strategic allocation to fixed income in more risk-averse client profiles – conversely lowering equity exposures – and extended bonds’ duration across portfolio risk profiles in anticipation of falling interest rates. Government debt now offers a higher return for lower risk than other asset classes. In particular, US Treasury returns should outperform cash and act once again as a diversification tool in portfolios as inflation normalises, after a string of negative yearly returns.

    Elsewhere in fixed income, investment grade credit in developed markets offers attractive yields and resilience, as low refinancing needs and less-leveraged balance sheets offset higher borrowing costs for companies. High yield credit is also likely to see more attractive, equity-like returns in the years ahead. We are therefore slightly increasing exposures to these segments in some profiles and are removing standalone allocations to emerging market debt in local currency, Chinese debt and convertible bonds across all portfolios.

    Looking forward, the balance of expected returns between fixed income and equities has shifted. The equity risk premium versus bonds has fallen, and is below historical averages, arguing for increased portfolio exposure to rates and spreads.


    Equities remain a core portfolio holding

    That said, equities remain a core portfolio holding. They give investors access to the long-term economic growth and profitability of companies, and their expected returns over the coming decade are broadly stable on previous years; at 7.6% they are still ahead of most fixed income returns. Our overall equity holdings across balanced and growth profiles remain the same.

    Equity returns are, and will continue to be, mostly driven by earnings growth

    Equity returns are, and will continue to be, mostly driven by earnings growth. However, the last decade of exceptional corporate profits will be hard to repeat since they were boosted by declining interest rate expenses and lower corporate tax rates. We expect corporate margins to partially normalise but remain above historical averages.

    We have adapted our regional equity allocations to reflect a greater US market weighting across all portfolio profiles. This underlines our conviction that US markets should, over time, continue to outperform the rest of the world. In addition, we want to reflect some home-market equity preferences, depending on clients’ profiles. To balance this, weightings to other regions will be reduced, in particular those to emerging markets and China. These simplifications help to remove the need for currency hedges for most clients.


    Why the path to higher rates will lead to lower rates

    Let’s now turn to the macroeconomic outlook underlying this portfolio structure. We see signs that post-pandemic, a series of key variables have shifted in the global economy. After a subdued response to the Great Financial Crisis in 2008-2009, Covid triggered a greater government appetite to accelerate economic recovery, facilitating a faster rebound than historically seen after crises. Governments look more likely to support their economies in future downturns and are more accepting of fiscal deficits to meet higher investment needs in sectors ranging from defence spending to the climate transition. More recently, we also see indications that productivity growth may increase, especially if artificial intelligence delivers on its promised dividends.

    This fiscal largesse, and the fragmentation of global trade and supply chains, also contributes to structurally higher inflation. Global competition will likely continue or intensify. The US is serious about de-risking from China, and the West more broadly is looking to offset Chinese imports through other suppliers, including those in emerging markets. That in turn creates a boom in capital expenditure, including the return of strategic industries to home markets. Meanwhile, job markets are tight and service-driven economies have become less rate-sensitive, which is one factor behind the US economy’s remarkable performance to date.

    Long-term demographic trends, such as rising longevity, have also pushed up savings, as has increasing income inequality in many nations. Meanwhile, an ageing workforce also argues for lower growth, a problem that China faces for the first time in the decade ahead.

    Low-to-negative interest rates may be past, but we do not expect to see very high rates either

    So while we remain in an environment of slow growth and surplus savings, and are moving towards more benign inflation and normalising interest rates, the ‘neutral’ level of interest rates for central banks – a rate that neither drives nor restrains growth – may now be higher. This affects the long-term landscape for multi-asset investing.

    The era of low-to-negative interest rates may be past, but we do not expect to see very high rates either. We expect US nominal rates to reach 3.5%, meaning that in real, inflation-adjusted, terms the cost of capital will be around 1%, double that of pre-2022. Reaching this nominal interest rate will take time, but assuming we do not see an external shock, central banks should start to cut rates from mid-2024, then accelerate monetary easing in 2025 as inflation comes under control.


    A word on updating our SAA

    These portfolio changes are a consequence of an update to our capital market assumptions as part of our regular review of Strategic Asset Allocations (SAA). This framework forms the backbone of our multi-asset portfolios. It is designed to guide our asset allocation process, based on macro assumptions and asset class returns expectations for the decade ahead. It combines both cyclical and structural elements, in line with studies showing that most of a portfolio’s performance comes from strategic portfolio positioning choices. As a result, we regularly review our SAA as part of our wealth management process to ensure that clients’ portfolios remain positioned for long-term success. We seek to build one of the most robust asset allocation frameworks available to private investors.

    The process for building the SAA is threefold: understand, forecast, allocate. We seek to isolate the structural trends that will be pivotal to the long-term performance of portfolios: what will happen to economic growth, inflation, demographics, and productivity? How are markets valuing different opportunities? Most importantly, as the ‘risk-free’ rate evolves, we try and assess its future path, which is the starting point for all assets’ expected returns.

    Important information

    This is a marketing communication issued by Bank Lombard Odier & Co Ltd (hereinafter “Lombard Odier”).
    It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication.
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