Alex Smith (left), Jo Masters and Graeme Mather

Investors need a diversified asset portfolios in volatile global markets as central banks continue to tighten monetary policy to quell inflation.

Speaking at Investment Magazine’s Absolute Returns Conference in Sydney earlier this month, Alex Smith, portfolio strategist at US fund manager Bridgewater, said investors need to build diversified portfolios across multiple asset classes with diverging characteristics and geographies to hedge against rising inflation and interest rates.

Current market conditions make it difficult for asset owners. “Assets compete with cash and that’s the primary reason every financial asset is down this year, with the most liquidity-dependent assets being down the most, whether it’s kind of the frothiest parts of the stock market, US equities and long-term Treasury bonds,” he said.

“How to deal with that is to protect a portfolio by having some assets that can do well when inflation is above expectations – real assets, maybe inflation-like bonds, certain types of illiquid assets and growth assets that can do well in a recession,” he said.

However, Smith warned the risk of a prolonged period of elevated interest rates if this phase of initial tightening is insufficient to deal with underlying inflation. “That’s when you can get significant wealth destruction and that is very risky. So having that environmental diversification, asset class diversification we think is going to be very important.”

Demand shock

The fiscal stimulation unleased by governments round to the world to counter the effects of locking down their population in the pandemic severely disrupted normal patterns of demand, pushing inflation to record levels.

“The fundamental problem was too much demand, which explained the broad shortages across the economy, while supply actually held up pretty well.” said Smith.

The sharp rise in inflation triggered a coordinated response by central banks globally to raise interest rates by increments not seen in decades, led by the US Federal Reserve. “We’ve got inflation at levels you’ve never seen before, unemployment at levels you’ve never seen before, we’ve got central banks that are undertaking one of the most rapid tightening cycles we’ve seen in history, against the backdrop of one of the largest credit cycles we’ve seen,” said Jo Masters, chief economist at Australian boutique investment bank Barrenjoey.

Interest rates still have some way to go to lower inflation to more acceptable levels but we are starting to see an expectation that central banks will start to move in smaller increments, she said.

Australia’s economy is likely to withstand a recession, said Masters. “I don’t think we’ll see a recession in Australia mainly be caught for two key reasons. The first one is our household and corporate balance sheets are in really good shape…and we are a net energy and food exporter, so our national income is being boosted by [rising energy prices and increased demand].”

Decarbonisation opportunity

While the decarbonisation of the global economy is providing significant opportunities for investors, the road map towards net-zero carbon by 2050 is less certain and riskier.

“What we’re seeing now with the energy crisis is a realisation that transition is much harder than we perhaps had thought and that we are probably going to have a bumpier transition road than we expected. The endpoint hasn’t changed but the near term has actually become more uncertain,” said Barrenjoey’s Masters.

Investors will need to ensure their asset portfolio is sufficiently resilient to withstand these risks, said Bridgewater’s Smith. “[Investors] need to prepare your portfolio for those risks, and make sure that you’re prepared, not just for example the physical changes to the earth, but the transition risks, and that you can be diversified with respect to that is going to be very important going forward.”

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