Navigating the noise in financial markets

To build resilience into portfolios, the key is to dial down the noise and focus on an orderly investment process. The cornerstone of this process should always be strategic asset allocation (SAA). A longer term horizon, active management, risk management and diversification are intrinsic to building effective portfolios.

Long-term horizon

The foundation of a resilient portfolio is a well-structured saa. This involves setting target allocations across asset classes based on expected returns, risk tolerance, time horizon, and investment objectives, and rebalancing periodically. By focusing on the long term, we can embed resilience into portfolios, while addressing shorter-term noise through active management and risk management. Each year, we review the investment landscape over a 10-year horizon and adjust our strategy to identify key opportunities and risks. Strategic long-term allocations typically remain stable unless there  is a fundamental shift in our expectations. For instance, in early 2024, we believed the attractiveness  of credit had improved, prompting  an increase to that asset class.

From an investment perspective, building resilience over a long-term horizon means taking into account factors such as increasing geopolitical tensions, economic fragmentation, technological innovation, demographics and climate change. These trends affect markets and regions, altering strategic priorities. For example, China is no longer the high-growth economy (see Figure 1) it once was, necessitating adjustments in its portfolio weighting relative to other Asian countries.

Climate change, has significant investment implications. It encompasses risks such as higher temperatures, natural disasters, and population movements, which can impact industries and increase insurance costs. Governments will need to make substantial investments to cope with global warming, adding to the strain on public finances already under pressure due to rising geopolitical tensions and defence spending. Many climate risks are not yet priced into financial markets, and the countries hit hardest by climate events are often the least able to cope. These factors influence decisions about which sovereign issuers’ debt  to invest in and how selective to be.

For corporate investments, risk management involves engaging with companies to ensure they adapt to issues like climate change. This is a journey that takes time, and a company’s ability to change and thrive in a changing climate becomes a selection tool. In the long term, companies that do not do adapt will be penalised, as financial markets gradually apply a risk premium to businesses that fail to recognise the need for change.

Active management

In the current environment, where interest rates are high (see Figure 2) and central banks are moving out of financial markets, investors need to be selective based on country, sector and company characteristics. This  is what we call active management.

During the Covid-19 pandemic,  price increases were relatively easy  to achieve. Now, as inflation abates and consumers feel more financial pressure, questions arise about which companies can maintain their pricing structures. Within the same industry, there can be significant differences between companies based on their robustness, emphasising the need  for active selection. Factors such as brand reputation and pricing power become crucial.

Risk management

Risk management is another key aspect of building resilience in portfolios. Part of this is accepting that market volatility is a normal part of the investment journey. It is common to experience negative territory at times. The key to navigating these lows is to set up a portfolio based on the SAA approach and then stick to the strategy, making intermittent tweaks as necessary. The old adage holds true: “It’s not about timing the market, but about time in the market.”

Diversification

Diversification is essential for building resilience into portfolios. It helps ensure that shocks are absorbed over the long term by spreading investment across different asset classes, each reacting differently to market cycles.

A classic 60/40 split between equities and bonds balances the higher risk and return potential of stocks with the lower risk and stability of bonds.

Expanding the investable universe from bonds and equities to include alternative assets can also provide additional risk-adjusted return opportunities. With equities having had a strong run, bonds are now gaining focus. We are seeking other sources of return in different asset classes, such as real estate, infrastructure and hedge funds. Private equity offers opportunities to diversify through different investment styles and vintages. The mix between liquid and illiquid assets is also an important decision.  A portion of a client’s portfolio should remain liquid to cushion against unplanned outcomes. Not every portfolio suits every investor,  so it is crucial to ensure the client is comfortable with the risk and illiquidity risk they are taking. This involves understanding their liquidity needs and revisiting portfolios regularly, as we do at the beginning  of each year.

By focusing on long-term saa, engaging in active management and risk management, and ensuring diversification, we can build resilient portfolios that navigate the noise  and withstand the test of time.