Inflation and uncertainty push investors to rethink long-term strategies

Amid an inflationary environment that could last years, if not decades, and unpredictable macroeconomic factors such as geopolitical tensions, institutional investors are being forced to rethink their long-term approaches to portfolio construction.

In some cases, that means making changes to both tactical asset allocation and strategic approaches.

"We think inflation is going to be somewhat higher for years and even decades to come," said Ben Powell, chief investment strategist for Asia-Pacific at the BlackRock Investment Institute in Singapore, in a video interview. "Our judgment is that particularly Western central banks will choose to live with slightly higher inflation — it won't be 6%, but it might be 3%. And that's a very, very big change on where we've been over the last 20 years."

The expectation of inflation being structurally higher for years will have an impact on portfolios and is a key part of a new investment playbook that BlackRock has constructed, Mr. Powell said. According to the asset manager's 2023 global outlook, the new playbook involves more inflation-protection assets, more granular takes on asset classes, and more frequent checks on investors' strategic asset allocation.

"We should be really clear; we are definitely not saying we should move to a structurally more trading-orientated mindset. It's still strategic- and math-driven. That's unchanged. What has changed for us is the market volatility, meaning that if you were to just check in every year or two, the markets might have moved very dramatically over that time. And you'll have gone much further away from where you want to be," Mr. Powell said. BlackRock had $8.6 trillion in assets under management as of Dec. 31.

Indeed, a BNY Mellon survey published in January found that asset owners now require an increase in the frequency and speed of reporting when it comes to portfolio performance.

"For example, if reporting used to be quarterly, it's gone into monthly, and more and more it's going daily," said Frances Barney, New York-based head of global risk solutions at BNY Mellon, in an interview during a recent trip to Singapore.

"It's really reflective of the importance of the fiduciary responsibility and the care that the investment office has with trying to achieve their investment objectives, whether it is protecting the retirement or the future of specific stakeholders," Ms. Barney said.

BlackRock is not alone in identifying the need for a new approach. Australia's A$243 billion ($168.1 billion) sovereign wealth fund Future Fund, Melbourne, released a position paper in December titled "The death of traditional portfolio construction?" The paper stated the need for fresh approaches to portfolio construction because of paradigm shifts.

These include trends such as the 30 years of globalization, Chinese growth, energy and food abundance, a peace dividend and interest rate declines that have provided tailwinds to investment returns but can no longer be relied upon, the paper said.

For example, "equities have always been the main driver of portfolio returns to long-term investors," said Raphael Arndt, CEO of the Future Fund, in a phone interview. "Apart from being fairly priced to begin with, for equities to perform, you have to have businesses that can generate earnings, so you need reasonable economic growth. And if they use leverage, you need stable interest costs."

However, there have been hurdles to economic growth globally, Mr. Arndt said. These include geopolitics, governance concerns, budget-balancing, inflation, and social or cultural changes.

He also noted that "over the next little while, and maybe that's 10 years, we think economies and markets are adjusting, inflation is going to be higher, and geopolitics will be more intrusive. … We have to keep an eye on our portfolio positionings, and we have to adjust the portfolio (as needed)."

That includes taking more possible scenarios into consideration in their risk management analyses. Even though scenario planning has always been a part of Future Fund's investment approach, the fund has found that the range of plausible scenarios today has widened notably, Mr. Arndt said.

"We could have a recession, or a deep recession, or interest rates could go too high, or there could be this policy mistake by central banks, or maybe we could have a spike in inflation that comes in stagflation, or we could have a muddle through and maybe even have a productivity boost," he explained.

In addressing today's scenario of high inflation and interest rates, the fund activated several new levers, according to the December paper. These include more defensive and inflation-protection levers such as gold, commodities, tangible assets and other alternatives, and more granular levers for developed and emerging markets.

Similarly, BlackRock advocates a more granular view on selected assets as opposed to broad global asset classes.

For instance, while fixed income is generally viewed as more favorable as interest rates rise, BlackRock views some types of fixed income as more attractive than others.

Within government bonds, the asset manager's views on each type vary widely — it is generally underweight on the asset class, but maximally underweight on nominal bonds and overweight inflation-linked bonds. Tactically, it is underweight long-dated developed markets government bonds and neutral on short-dated government bonds.

On long-dated bonds, Mr. Powell explained: "In a world of very high certainty, very stable inflation and policy, if you asked me, if I buy a 10-year Treasury yielding 3.5%, will that be a good return? If you have very good foresight on where inflation or policy is going to be 10 years forward, you can have a high conviction answer."

"Now, if you buy a 10-year Treasury or a longer-duration asset, particularly a nominal asset, which can't keep up with inflation, is that going to be a good trade or not? The answer is, we are much less certain than we were," Mr. Powell added.

Kamal Bhatia, New York-based chief operating officer for Principal Global Investors, observed a similar trend in which institutional clients are not simply asking for debt over equity, or private over public investments.

"Diversification is back in vogue," Mr. Bhatia said. "Bonds are also back in vogue, and I think there is a better understanding of the risk in equities."

There are specific areas in fixed income that he's hearing interest about, particularly in investment-grade fixed income, and less risky high yield "that is not investment grade but has substantial risk-reward," he said.

Institutional investors have also been grappling with the change in correlations between equity and bonds, Mr. Bhatia said.

"We've had for the longest time in this environment where rates would either come down or stay. It's been a while since rates have moved this viciously. And when they move that quickly, you get very different macro behavior, and you must have models that have to understand correlations differently. So a lot of clients are really thinking about that part of it," he said.

That said, even as institutional investors try to cope with this new macro regime of persistent inflation and volatility, there remains uncertainty over how long this environment will last.

"We believe average stock-bond correlations will be less negative and that you can no longer rely on persistently negative correlation," BlackRock's Mr. Powell said. "This is not to say stock-bond correlations will never be negative. They may be for periods of time, but this cannot be relied upon over extended time horizons."

Future Fund's Mr. Arndt agreed: "We're not saying that a 60/40 portfolio will never work, but I don't think it will work in all scenarios. And we also have a portfolio construction approach that works better — one that you can rely on for all the times we think it's important."