Stretched valuations and inflation risks change asset allocation

Stretched valuations and inflation risks have generated the new challenges for asset allocation, according to First Sentier Investors (FSI).

FSI’s paper on “Asset allocation challenges: Five questions to ask” found that at the global level the post-pandemic recovery in equities was uneven, both at the sector level and individual company level.

Further to that, it stressed that conventional asset allocation was based on the idea that equities and bonds moved in opposite directions, particularly during periods of more extreme volatility. 

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However, in the period ahead, there were examples over longer periods of time where equities and bonds actually moved in concert with each other.

“While we continue to see diversification benefits from high quality fixed income assets, we are not being complacent. We could easily see an environment where both fixed income and equities fall in tandem – and one could even cause the other. For example, if yields suddenly rose or central banks had to aggressively hike interest rates to curb inflation, it would likely hurt equities as well,” Kej Somaia, co-head of multi-asset solutions said.

The firm also argued that central bank activity was the single biggest driver of asset performance over the past decade, thanks to an enormous amount of liquidity and it warned that many investors were behaving as if this liquidity would last forever, but it should not be taken as a certainty.

“Central banks may be running out of monetary policy ammunition. While 2021 is unlikely to see a rise in cash rates, the pace of the global recovery could see markets rethink the ‘liquidity forever’ theme and prompt investors to revisit their assumptions,” Somaia said.

As far as inflation was concerned, FSI said that the current global recession made the prospect of inflation less likely than deflation at the moment but this was asymmetric risk that investors should look out for when managing a multi-asset portfolio and a sudden and unexpected inflation shock might be painful for both fixed income and risk assets, simultaneously.

“A static approach – particularly in the defensive side of the portfolio – will make it difficult to deliver on many investors’ long term return objectives. Taking the average market return will only get you so far; the key is to remain flexible and respond to changing conditions,” Somaia noted.


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