A new market paradigm

“The current market environment is one of the most challenging I have ever faced in my career,” says our Group CIO Yves Bonzon. As the red-flashing numbers on our preferred finance applications tell us, aside from cash, energy companies, and commodities, there is hardly any place to hide (and even the last two have been a poor hedge in recent weeks).

And while we still believe that we are most likely in the midst of a cyclical bear market driven by liquidity reduction rather than a US recession, the hard truth is that the world will probably not return to its status quo once the dust settles.

Geopolitical pull

Going forward, geopolitics, rather than economics, is in charge. De-globalisation will accelerate as governments work to onshore those complex and efficient supply chains whose dependence on unreliable partners has been laid bare in the wake of the war in Ukraine. The push for domestic investment, in turn, will reignite the flame of private sector borrowing in developed economies.

For investors, this means bracing for higher average inflation (i.e. somewhat above central bank targets but lower than the current red-hot readings), as well as higher volatilities.

Portfolios that have been positioned for 30 years of disinflation and relative political stability will have to shift gear to survive the new market paradigm.

The impact on portfolios

There are two major changes investors need to consider when it comes to portfolio construction.

First, the increased geopolitical turmoil and the now clear willingness of governments to instrumentalise the financial system to punish non-compliant countries means that the geographical scope of portfolios needs to be carefully defined. Investors should be willing to accept the risk of capital confiscation in case investments in a particular country are sanctioned.

On our part, we have decided to tactically and strategically decrease to zero our standalone allocation to Chinese equities, as they are exposed to a heightened risk of both domestic regulation due to the country’s ‘common prosperity’ goal and to external punitive measures in the context of China’s tensions with the US. We remain exposed to China through the broad Asia index (excluding Japan).

Second, with inflation becoming a more persistent feature, fighting against capital erosion is more important than ever. The key to surviving an inflationary investment environment is to favour real over nominal assets in a portfolio.

What is the difference between the two? Nominal assets represent a claim to a numerical value (e.g. cash, the principal amount and coupon payments of a bond denominated in a particular currency), while real assets are a claim on something with an intrinsic value. Examples of real assets that immediately come to mind are commodities, gold, and real estate, which are linked to the physical world. But many forget that equities, both public and private, which give investors ownership of a company whose value is linked to its future profitability, are also real assets.

In the case of bonds, investors demand higher yields, which in turn decreases valuations. For real assets, that is not necessarily the case. The value of a company can either increase or decrease, depending on how high the price pressure on its costs and products is and how well positioned the company is to protect its profitability. Historically, real assets have indeed outperformed cash and bonds during elevated, but contained, periods of inflation.

How to preserve wealth

While favouring real to nominal assets will be crucial to preserve capital in a sustained inflationary environment, overall portfolio construction and diversification remain the keys to success.

Piling into public equities might be more than the average investor would ask for in terms of volatility and may not lead to a sustainable risk-adjusted allocation.

When it comes to commodities, the management of the asset class in a portfolio context over the medium to long term may be tricky, and we prefer to see it as a tactical, rather than a strategic, opportunity. In the same vein, gold is a hedge primarily against financial instability risks, which we do not expect to materialise in the US or in Europe.

Moreover, there are other asset classes that exhibit the same volatility over long periods of time as gold does but that offer higher returns.

One real asset class that should be considered in the context of a well-diversified portfolio, particularly in the current economic and geopolitical landscape, is private equity. The relentless hunt for returns in an ultra-low-yield environment has made the rise of private equity markets one of the biggest trends in finance over the last decade.

This, however, is the past. Going forward, the economic playing field is changing, and we are looking at the end of the ultra‑low-yield environment. Nevertheless, the merits of private equity are not undone; far from it, they can be very useful to investors in times of increased uncertainty.

A closer look at private equity

While it may be entertaining to watch the real-time performance figures of our investments on our smartphone, especially when most of the screen is shining green, doing so is also a critical source of error, especially when all we see is red. This constant flow of information increases the likelihood of taking the wrong decision at the worst possible moment.

We know that the average investor tends to underperform a long-term buy-and-hold strategy because they trade too frequently, rebalance their portfolio too often, and fail to time the market successfully.

This is one of the reasons why we see private equity as an interesting asset class, especially in these uncertain times. Additionally, with public markets currently offering little place to hide, private equity investments provide important access to a growing opportunity set. For some time now, public markets have experienced a trend of de-equitisation: the number of traditional initial public offerings has been trending down and the time companies take to go public has increased, effectively shrinking the total number of companies publicly traded.

By contrast, the number of privately owned companies has been increasing steadily, opening up new opportunities for long-term investors while improving their risk/return profiles and further diversifying their portfolios.

The illiquid nature of private equity funds protects investors from themselves, helping them to stay invested and, in the end, reap the gains of their long-term investments.

In the end, of course, what really matters is the enhanced performance that an allocation to private equity can offer. But this is exactly where the challenge for this asset class lies. For while past performance has been attractive, the outperformance generated has been concentrated in the top quartile, while average returns have been roughly in line with public markets.

What does this mean for interested investors?

While including private equity in a portfolio is important, it is crucial to have access to the top fund managers, which in turn means relying on experienced advisors and a broad network of experts and professionals in the field.