We have devoted several recent editions of CIO Weekly to politics, elections and central bank policy. All of these issues will continue to loom large. Indeed, this week we have the Dutch election and the likelihood of a rate hike by the US Federal Reserve, both of which my colleagues will comment on. These developments are all part of the drum beat we’ve been listening to and considering over the last few months. These are important issues and we will return to them in subsequent weeks, but at this point it seems timely to pause for breath and refocus on the basics.
Back in December, we published our Solving for 2017 outlook. We identified 10 key themes for the year ahead, including the likelihood of a rising interest rate environment, higher inflation and more political uncertainty, all of which have come to pass. But while it’s important to be mindful of the day-to-day headlines, it’s also important that investors look beyond what my colleague Brad Tank calls “the signal-to-noise ratio” — or, to put it another way, to block out the hubbub and focus on the basics.
Solving For 2017 also identified a number of strategies that we suggested investors might consider deploying in the current environment. Among the most important were broad diversification strategies and the need to structure portfolios against a backdrop of heightened volatility.
Diversification is key
Historically, investment grade bonds — principally government bonds — provided investors with the primary source of diversification for equities and other risky assets. But in a rising rate, higher inflation environment, bonds are likely to be less effective as diversifiers. Instead, investors need to consider other sources of diversification such as inflation-sensitive assets and alternative risk premia.
On the first point, we have been in an extended low inflation environment during which many investors have overlooked or underweighted inflation-hedging assets. But in the current market, inflation-linked bonds and commodities have important diversification qualities.
Alternative risk premia, meanwhile, can also diversify investors’ portfolios with the potential to help narrow the return gap between return objectives and the current return profiles for traditional market exposures.
Make volatility your friend
The second strategy involves dealing with volatility. To date, we haven’t seen much in equity markets, although there have been plenty of minor outbreaks in currencies, commodities and even some sectors of the stock market. However, we have no doubt that equity market volatility will return. For evidence, one only has to look at the raft of highly charged elections coming up in Europe this year, as identified by my colleague Joe Amato last week.
When volatility does reappear, savvy investors will have an opportunity to work it to their own advantage. Again, they can do this through diversification, using volatility-capture strategies. These include index option writing, which represents a less volatile approach to equity exposure and can also be used to generate regular income. In fact, in a rising rate environment with heightened volatility, income-oriented strategies can be very helpful for investors. That’s because, with a regular cash flow, investors have the opportunity to reinvest at higher rates and/or better prices.
Additional income-oriented strategies with lower interest rate risk include investing in bank loans and, for those investors that can take on illiquidity, private debt strategies. Focusing on vehicles that can generate income or yield without incurring interest rate risk is important. They’re another useful instrument in an investor’s tool kit.
To conclude, there is a lot of noise in the market right now and I have no doubt that it will continue, with more to come on government initiatives, central bank policy and elections in the coming months. There’s also likely to be more volatility. But at a basic level, smart investors should be quietly building their portfolios for long-term success.