As we have repeatedly emphasised in the past, growth is the norm - most years world output grows because of the simple interaction between new technology and the learning curve.
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The inference is that we need to find good reasons for positioning against that trend, with investors usually being better off with exposures supported by continued growth. Broadly speaking, history is on the side of the optimists, and that means investors are best served in the long term by tilting their portfolios towards risk assets such as equities, rather than traditional safe haven assets.
For now, our preferred indicators are telling us that the end of the cycle isn’t imminent. Until they start flashing amber, the Tactical Asset Allocation Committee sees no reason to deviate from its current stance with an overweight in risk assets. This is further compounded by our concern that one of the most popular safe havens, government bonds, may be offering a period of return-free risk rather than risk-free return. However, the global economy is vastly complex, and we know far less than we imagine. We may be wrong about the near-term prospects for the economy – models can be mis-specified, and unforeseen risks may erupt without warning.
By spreading investments across a range of assets with varying degrees of sensitivity to the economy, we attempt to insulate our portfolios against unforeseen and undesirable outcomes. Comments about portfolio diversification broadly revolve around two broad asset classes – equities and fixed income. In reality, portfolios have a wider set of asset classes to choose from, not to mention that sub-asset classes (e.g. Emerging Markets Equities, Investment Grade Bonds etc.) have different risk characteristics as well. Having a wider opportunity set allows portfolios to reduce their allocations to Developed Government Bonds without having to sacrifice diversification. Figures 14 and 15 illustrate this nicely – when equities have performed poorly, it isn’t just Developed Government Bonds that outperform, other asset classes such as Alternative Trading Strategies (ATS) and investment grade credit tend to do well too.
Beta - An indication of whether an investment is more or less volatile than the market. In general, a beta less than 1 indicates that the investment is less volatile than the market, while a beta more than 1 indicates that the investment is more volatile than the market.
Accordingly, portfolio diversification shouldn’t be viewed in terms of a simplified bi-allocation between equities and fixed income, but rather in terms of its beta, or the portfolio’s overall relationship to equity markets and fixed income. Within our client portfolios, the presence of safe havens and other diversifying assets, plus the proportions in which we own them, have been successful in restraining that beta in both good and bad times. In the current environment we still see Cash and Short-Maturity Bonds as the most reliable nominal safe haven, providing liquid and stable ballast in portfolios. We augment this stable, but low returning core safe haven, with some government bonds, investment grade credit, and alternative assets with a negative beta to equity markets. At some stage, government bond yields may return to levels that start to offer the kind of real returns and nominal stability that we would demand of a safe haven asset. Until then, investors will have to continue to look to the less traditional asset classes to provide the same valuable service.