Global Asset Tracker: Clients urged to abandon conservative mindset

With fixed income and cash no longer delivering, CIOs are urging clients to embrace equities and alternatives  [note this article went to press before the Russian invasion of Ukraine]

As central banks tighten monetary policy to keep inflation under control, private bankers may be having a hard time making asset allocation recommendations to their risk averse clients, spoiled by a long bond bull market. Seeking alternatives to income generating strategies is also important, as income repression is set to continue.

In the current environment, clients should adjust both their portfolios and their mindset, warns Manuela D’Onofrio, head of investment strategy at UniCredit Group. “European private clients tend to hold very conservative portfolios, with a high exposure to bonds and cash,” she says, estimating their average equity allocation is not higher than 30 per cent.

But as bond interest rates rise and real yields are likely to remain negative for a while, “keeping this prudent balanced profile is not a good idea”, she says.

“Conservative clients benefited from the bond bull market but this year they are going to lose money on their bond holdings, and it is going to take them a long time before they recover from this drawdown, unless they increase equity exposure going forward,” she warns. Euro-denominated aggregate bond funds, investing in a wide range of assets, delivered very good performance up to the end of 2020 using the carry trade strategy, but with quantitative tightening, it is no longer going to pay off.

Keeping cash is out of the question as well, since inflation erodes purchasing power of savings.

She recommends clients take advantage of market volatility to gradually increase exposure to equities. With 2022 set to be a “bumpy year”, clients  need to have longer-term goals.

“Clients should lengthen their investment horizons. They can no longer look at returns at the end of each calendar year, as they have done over the past 10 years,” says Ms D’Onofrio.

Investment themes can turn out to be useful in this context and private bankers are increasingly focusing on ESG and thematic investments “to lengthen the investment horizon, boost returns and increase portfolio diversification,” says Ms D’Onofrio.

“Clients are much more interested in investment themes than geographical asset allocation,” she says, and active management, expected to outperform passive as central bank liquidity tightens, will allow taking advantage of opportunities as they arise.

Ninety per cent of private banks today have an underweight tactical allocation to bonds, according to PWM’s Global Asset Tracker survey. Yet, fixed income remains a foundational asset class with a critical role in portfolios (see Figs 1 and 2 on page 13, and Fig 3 on page 14).

In a rising rate environment, where bonds are not providing the same diversification or returns as in the past, investors should seek “unconventional yield”, which UBS finds in dividend equities or US senior loans, the latter seen as floating-rate alternatives to high yield debt. “We don’t see default rates ramping up massively from here,” says Mark Haefele, CIO, UBS GWM, expecting stimulus in the system to continue, supporting economic growth.

Investors must also look further afield to find yield, for instance to Asian high yield. “A rising rate and rising yield environment increases risks to high grade and investment grade credit, particularly at a time when spreads are relatively tight. We prefer private credit, senior loans, and volatility selling strategies as ways of generating income,” states Mr Haefele.

Hedge funds can also be a way of navigating interest rate risk, especially when correlations between bonds and equities are relatively high, he adds.

Unconstrained and total return fixed income is the part of the bond market CIOs believe will provide the most attractive return opportunities, with emerging market corporate bonds and government debt also considered relatively appealing, together with alternative credit and green bonds (see Fig 1).

“Within the fixed income space, investors should keep a low duration until central banks implement their normalisation trend,” says Vincent Manuel, global CIO, Indosuez Wealth Management. “Short duration high yield and subordinated financials probably offer the best risk/return within mature markets fixed income, in this environment.” Some opportunities can arise in emerging markets that have already increased interest rates and control inflation.

Income repression looks set to continue, if bond yields stay below nominal GDP growth and real rates remain low or negative, explains César Pérez, head of investment and CIO at Pictet Wealth Management. “With the returns outlook for developed market government bonds set to remain subdued, income-seeking investors must seek alternatives,” he says.

The bank remains underweight government bonds, and continues to like “dividend growers”, namely companies that can increase dividend payouts to investors in a sustainable way. A growing percentage of equities offer dividend yields higher than corporate bond yields, he says. Pictet also sees income opportunities in foreign exchange markets.

“Tightening monetary policy in countries with sound fundamentals has created a number of high quality cyclical currencies that offer an attractive interest rate and can provide portfolio diversification benefits,” says Mr Perez.

While keeping duration level shorter is key to protecting fixed income from rising rates, buying bonds with different maturity rates, or ‘bond laddering’, is also believed to be an effective strategy to respond relatively quickly to rate changes.

But as interest rates drift higher, investors should get ready to catch long-term opportunities arising in fixed income.

“As the 10-year Treasury yield grows to 2.5-3 per cent, fixed income will start becoming more attractive from an asset allocation perspective, especially as earnings’ growth of the S&P 500 slows down meaningfully. That will be a time to think hard about asset allocation. But that time is not today,” says Niladri Mukherjee, head of portfolio strategy, chief investment office, Bank of America Merrill Lynch.

“A big part of the bond market has become uninvestable for private clients and you need to find pockets where you can get positive real yield,” says Lars Kalbreier, global CIO, private banking, Edmond de Rothschild. This may be offered by Chinese government bonds or subordinated financial debt, but investors should also go into less liquid assets such as private debt. Thanks to continuous education, today clients are more willing to trade off lower liquidity for a higher real yield, he adds.

Private equity and private debt are the asset classes to which the highest proportion of private banks expect clients to increase their exposure this year (see Fig 7 on page 15).

“One of the key trends we’re going to see is more and more private markets added to private investors’ tool sets.” These will no longer solely be the domain of institutional investors. “We will see the democratisation of private assets, private debt and private equity, but also infrastructure debt,” states Mr Kalbreier.

“This year will be one of transition as the economic recovery cycle matures into a mini-cycle,” adds Norman Villamin, CIO, wealth management at UBP.  “Negative inflation adjusted yields will continue to be an issue, even as the Fed tightens. So, alternative income strategies in hedge funds, private markets, real estate, infrastructure, which can opportunistically capitalise upon rising volatility, will be important to generate positive return, as well as seeking to generate near inflation rates of return.”