Multi-asset allocation views: Five lessons for investors during turbulent times

Read this article to understand:

• Why building asymmetry into portfolios can be an effective way to manage risk
• Three key considerations for investors if stagflation materialises
• Why cash and gold can still play a useful role in protecting portfolios

The Russian invasion of Ukraine, which began on February 24, has already had a significant impact on economies and financial markets, extending well beyond the two countries involved.  

Managing risk and protecting client assets is an essential part of portfolio management. In this article, Sunil Krishnan, head of multi-asset funds at Aviva Investors, offers five lessons for investors during times of uncertainty and heightened volatility. 

In doing so, it is important for us to repeat our public position on the conflict: First and foremost, we are extremely concerned by the events unfolding in Ukraine and our thoughts are with all Ukrainians at this time. Further details on Aviva Investors’ position can be found here.

Lesson one: Tail risk is important, but investors shouldn’t obsess over it. Capturing asymmetry in portfolios is far more useful

While there were some prescient voices who talked about the increasing risk of a militarised Russia, it was not seen as a big danger.

That should teach us something about how confident we should be about our central cases, and that even when we try and map out scenarios in advance, it is not possible to capture all macro risks. One thing we are always trying to do in portfolios is capture a degree of asymmetry, essentially a way to make sure the downside you might be exposed to if things don't go according to plan is less than the potential upside you might receive. And you can find that in both naturally defensive positions and naturally cyclical or growth-sensitive positions.

We try not to get too caught up in the three-month outlook but look to longer-term dynamics. That can sometimes give us that sense of asymmetry whereby, even if the business cycle doesn't turn out the way we think would most favour a particular trade, you would perhaps lose less money, or benefit from a later recovery, because of the long-term structural drivers. 

Take our position in healthcare companies; most investors would say that is a defensive position because one of the qualities of healthcare is earnings stability, which is only valued by investors if they are worried about earnings elsewhere.

Our view is different: we found a place in the portfolio for healthcare because of secular drivers such as developments in technology; a potentially more conducive regulatory environment for research and development; and demographics increasing demand for healthcare products and drugs. That is a constructive combination, irrespective of whether the economy speeds up or slows down.

Figure 1: MSCI World Health Care index performance, gross returns (US$) 2007-2022

Past performance is not a reliable indicator of future performance. For illustrative purposes only, not intended as an investment recommendation.
Source: MSCI. Data as of March 31, 2022¹

There is also the question about what to do when a risk does materialise. Investors often become defensive because they are worried markets are complacent about the consequences. There is probably something to that, but one needs to be humble about how long the window can last for during which we have an analytical edge over the market. 

In the case of Russia’s invasion of Ukraine, only in the two weeks preceding did we come to see material military action as inevitable. We undertook some risk management steps on the back of that, but on the day of the invasion our edge versus the market on that issue essentially disappeared. We were dealing with news in the public domain, and no better informed than anyone else.

It is important to understand that, even if at times there are informational advantages to be had from being more aware or attuned to the significance of a risk, they are often fleeting. Once those have passed, one also needs to recognise that, from any position, a situation can get better as well as worse. 

Moreover, some important themes, risks and opportunities are not affected by events. Take the Federal Reserve, which now sees itself as being behind the curve in terms of dealing with US inflation. Its plans to tighten interest rates are not being derailed by the significant uncertainty caused by Russia's invasion of Ukraine. It has started its interest rate hiking programme; a week after that first rise, the chairman said a further 50-basis-point hike in May was possible.

That is a strong message, but if Russia-Ukraine was the only theme on your radar, you might expect government bonds in the US to rally out of a pure safe-haven bid and position accordingly. However, that has not happened, and yields are actually at the highs of the year across most of the curve in the US. 

Figure 2: US Ten-year Treasury yields - 3 months to April 4, 2022

Past performance is not a reliable indicator of future performance. For illustrative purposes only, not intended as an investment recommendation.
Source: MarketWatch, April 4, 2022²

Lesson two: The effect of geopolitical risk on markets is often overstated, but this time may be different

For a long time, there was a running joke that when geopolitics featured top of investor surveys on what they were worried about, it meant everything was great because they were relaxed about bigger market drivers like inflation, interest rates or recession risk. The right approach to take to geopolitics was to see it as quite temporary in terms of its importance. 

A good example would be trade tensions between the US and China in 2018, which were for a period an important driver of risk sentiment. In the fourth quarter of that year, we saw weak performance from risk assets, but it was not sustained and through 2019 we saw a very strong recovery that took back all the declines. 

Figure 3: Trade wars in 2018 were a passing worry – MSCI ACWI performance, 2017-2019

Past performance is not a reliable indicator of future performance. For illustrative purposes only, not intended as an investment recommendation.
Source: Bloomberg. Data as of April 11, 2022

Having said that, there are times when the changes are structural. If you look back through history, you can point to the build up to world wars, the evolution of the Cold War, including the fall of the Soviet Union, as events that were very important to markets. We can also look at certain events as representative of a much broader change, for example in 2001 with China’s accession to the World Trade Organisation. That was symbolic of globalisation and the extension and interconnectedness of supply chains to come.

We may be at one of those moments now. There are two reasons to consider this a serious possibility. One is not so much Russia's action, but rather the West’s response, which has surprised many in terms of the extraordinary degree of coordination between parties who often disagree over issues. That willingness to support severe sanctions against Russia is not restricted to the West but extends to countries such as Australia and Japan. The idea of shared values between developed countries has been derided for many years; recent events suggest there may still be substance to this.³

Analysts of Germany’s post-war defence policy would never have expected to see a German Chancellor announce their intention to catch up to their NATO commitment in terms of defence spending as a percentage of GDP. Pollsters in Finland and Sweden would never have expected NATO membership to come onto the agenda of these countries so quickly. This raises the question of where else that solidarity might take us. We don't have the answers yet, but need to start thinking about that question.^4,5

The second potentially lasting impact is what happens between the West and China. At the moment, the focus is on the extent to which China is willing to work with Russia, and whether it may put Chinese sovereigns or companies on the wrong side of Western sanctions. That would have important consequences for globalisation.

Even if China succeeds in walking the tightrope between maintaining economic relations with Russia and not antagonising Western powers, a greater willingness among Western governments to talk about a more values-led foreign policy could lead to other disputes and disagreements with China. It is important for investors to consider these possibilities.⁶

Commodities are a big theme in markets right now. We were experiencing disruption prior to Russia-Ukraine, but are now seeing that to a much greater extent (Figure 4). It is hard to have a view on the longer-term outlook for commodities without a view on how Russia-Ukraine and sanctions against Russia play out. But it also becomes vital to understand where your commodities exposure is – for an emerging markets investor, the difference between investing in a Russian energy company or a Brazilian one is material.

Figure 4: Commodity price increases have accelerated

Source: Bloomberg, Aviva Investors. Data as of April 11, 2022

These kinds of factors are now in play, so no one can afford just to laugh off geopolitics anymore.

Lesson three: Stagflation is likely to bring more volatility and market corrections, but there will still be opportunities

It is tempting to think of stagflation as a re-run of the 1970s, with double-digit inflation and recessions at the same time. But given what we have become used to in terms of low volatility, low nominal interest rates and low inflation, a combination of inflation higher than the last 15 to 20 years along with a slowing economy could have profound implications. If you define it that way, we are already in stagflation and have been for some time. We may just want to call it ‘stagflation lite’. 

Figure 5: Inflation rising as growth slows (per cent)

Source: Bloomberg, Aviva Investors. Data as of April 11, 2022

There are three consequences investors need to be aware of. First, and most directly, we are likely to see a higher nominal interest rate environment across the yield curve. We have seen large moves in terms of safe-haven government bond yields, and our base case is that we are not done yet. While we will still use government bonds for diversification, we need to size those positions in a way that reflects much more two-way risk. 

A second consequence is we will need to look carefully at the financing position of various economic agents, whether that is households, companies or sovereigns. Investors have not had much recent experience of judging how rising interest costs may affect the liquidity and solvency of issuers, but they will need to think about that more seriously. 

Again, that does not mean there will no opportunities. For some time, the risk-reward in investment grade and high yield credit was not attractive. However, spreads have widened as investors have tried to understand the challenges for issuers (Figure 6). We have moved to close our underweight in those positions, but it requires a degree of selectivity: in the Warren Buffett phrase, the tide of liquidity is gradually going out. We expect it will catch some people out with invisible bathing trunks.

Figure 6: Credit spreads have widened (per cent)

Source: Bloomberg. Data as of April 11, 2022

The third consequence is that investors will need to brace themselves for more volatile markets to be the norm, and calm periods to be brief. We believe a higher volatility regime is something else investors should expect. Investors will constantly have to weigh up this tension between “are we tipping over into recession because interest rates are rising?”, or “are interest rates rising too slowly, in which case we may have runaway inflation?” We think it is unlikely we will continue to have extended periods of strong returns in risk assets, unbroken by concerns about when the business cycle might end. 

This does not necessarily mean total returns can't be positive – we are overweight equities, which should tell you something – but investors should expect more volatility and corrections. That may provide opportunities but again, from a position sizing point of view and what may protect us in market downturns, we need to run portfolios with more humility now about what the short-term outlook might bring.

Lesson four: Investors should not rely on single measures to assess the risk in their portfolios

Even when markets are calm, in the world of tactical asset allocation we are suspicious of mainstream measures of risk like tracking error. Asset allocation positions by nature are quite lumpy, in the sense they can be subject to key themes – like Russia-Ukraine or inflation – that will affect a number of positions at once, even in a portfolio that might look diversified. 

Something we have found recurrently, particularly in relative-value positions, is that the returns that can be realised, both positive and negative, are routinely outside recent historical experience. This is why we tend to be conservative in terms of position sizing and remain open to the unexpected. 

The second point is that correlations can be unstable. If a correlation between two diverse assets turns sharply positive, even for a short period of time, it can still be quite painful. What you had carefully set up as a well-balanced, diversified portfolio doesn't behave that way. We try not to rely too heavily on single-point forecasts to assess portfolio risk and look through a number of lenses; for example, asking what the contributors to risk are, not just by asset class, but by factor, particularly economic factor or economic regime. 

We also look through the lens of history. Do we understand the historical periods we have been most exposed to in the past that would have led to the best and worst returns?

For example, because portfolios that run large emerging-market positions can express this across a number of asset classes, that risk is dispersed and can be hidden. A historical approach can be helpful to understand how events played out, and how and where the risks materialised.  

At the same time, no two crises are exactly the same, so we prefer to research this during calm times because it gives us an idea about where we should be focusing. And sometimes we can then be creative in the middle of a real scenario. 

When we see changes in correlation structure, we try and understand whether they might be persistent or temporary. For example, while we still think the correlation of bonds with equities is not going to rise to one on a sustained basis and, to that extent, bonds will continue to have a role in diversifying portfolios, can we expect the consistent negative correlations we got used to in the period of disinflation? We don’t think so, and must be prepared for periods when the correlation flips.

Sometimes, in a more normal environment where bonds are negatively correlated to equities, it can be hard to work out whether we would rather be a buyer of equities or a seller of bonds, as they amount to the same thing. These days, they don't necessarily, and it can be quite clear one of those is a better expression of our conviction. Being willing to spot opportunities, even though they don't necessarily come across all capital markets at the same time, is important.

One of the ways government bonds help in portfolios with heavy equity exposure is by making sure portfolios do not crash entirely when equities go down. Other investments can do that job too, and we also use alternatives such as absolute return funds – as long as they can be accessed in a cost-effective manner and have sufficient liquidity. 

Another option, which might seem counterintuitive at a time of rising inflation, is cash. Compared to normal times, we are leaning more heavily on cash, and a bit below average on government bonds. Cash is more flexible as it can be deployed quickly when opportunities arise, whereas government bonds have seen and will continue to see some chipping away at capital values and more daily volatility. 

Lesson five: Gold is not just cryptocurrency for old people

At various times, we have been challenged on our gold position. Some sceptics view it as a less-liquid alternative to inflation-linked debt, or even an “old person’s version of cryptocurrency”. 

We have persisted with gold partly because of its heritage and market depth, with experienced buyers and sellers internationally. But it can also be useful for investors in a number of scenarios. We introduced it to portfolios because we believe it does well when there is uncertainty about the monetary policy regime – although it is not as simple as saying it always goes up if inflation goes up or interest rates fall. 

Figure 7: 12-month gold prices

Past performance is not a reliable indicator of future performance.
Source: Monex Precious Metals, April 4, 2022⁷

We are in such a scenario now, with central banks facing rising inflation and slowing growth. It has been so long since we have had higher interest rates, how sensitive will the economy be if central banks start hiking?

Given the uncertainty, we are not surprised to see gold perform well. Nevertheless, those types of scenarios cannot always be forecast, which is why we see gold as a structural part of the portfolio.