Global Asset Tracker: Flexible thinking required to safeguard client portfolios
Rates hikes and persistent rising inflation are seen as the biggest risks for financial markets this year [note this article went to press before the Russian invasion of Ukraine]
The assessment of potential risk scenarios is of key importance in asset allocation decisions, and involves the analysis of the impact of risk events on financial markets and the economy, as well as the likelihood of their occurrence.
Full results
Download a PDF of the full results of PWM's Global Asset Tracker survey here
Sticky, persistent inflation is perceived by private bank CIOs as the most likely and high impact risk for financial markets this year, as it would lead central banks to hike interest rates more rapidly than expected, slowing economic growth and negatively impacting financial returns. This is a key finding from the seventh annual PWM Global Asset Tracker survey, conducted in January, canvassing asset allocation views from 52 private banks’ investment professionals (see Fig 1).
“Without a doubt, the biggest risk for risk assets is the persistence of inflation, which would lead to a more hawkish Fed, which might also mean pressure on corporate earnings,” says Jim McDonald, chief investment strategist at Northern Trust.
“The uncertainty around pace and trajectory of central bank rate hikes and quantitative tightening is the biggest risk and will drive volatility across markets,” states David Storm, CIO Wealth Management International at RBC.
“We expect rates markets to overshoot to the upside and equity markets to overshoot to the downside, which means we have to be flexible in our thinking and nimble in our positioning to take advantage of those opportunities.”
Building client portfolios in this period requires a much broader set of tools than fixed income and equity, yet many investors continue to constrain themselves, he adds.
Softening inflation
However, most respondents believe inflation is going to soften, as demand shifts from goods to services, supply bottlenecks improve and base effects of energy costs become more favourable. Moreover, there is widespread belief that central banks may not be so worried about higher inflation, because of governments’ very high debt levels.
“I think central banks are very comfortable accepting higher levels of inflation, because it is a way of deflating their debt level. And that’s, of course, the whole political side of what they’re doing here,” says Michael Strobaek, global CIO, head of investment solutions and products at Credit Suisse.
The Fed’s hawkish stance may even provide investment opportunities. “The Fed’s significant turn towards hawkishness in the face of a naturally softening inflationary picture may result in a slower-than-expected rate-hiking cycle and thus potential upside for risk assets,” says Fahad Kamal, CIO at Kleinwort Hambros.
“However, we retain a range of defensive safe haven assets, notably gold and our ‘tail risk protection note’, for those ‘unknown unknowns’, likely exogenous shocks, causing market turbulence.”
A low probability but high impact risk would be the emergence of a new contagious Covid variant, which is resistant to existing vaccines. If new lockdowns did become necessary, governments would no longer be able to support the economy, because of their much higher debt levels when compared to pre-pandemic times.
Geopolitical
Despite concerns surrounding the possibility of a Russian invasion of Ukraine, investment professionals tend to discount geopolitical risks as transitory for financial markets.
“It’s impossible to have confidence in a forecast of what’s going to happen between Russia and the Ukraine and the West. And so, making changes in investment programmes and portfolios based on something that’s completely unforecastable is just a bad idea,” says Northern Trust’s Mr McDonald. “But historically speaking, geopolitical events have just proven to be transitory in the financial market.”
“Unless it has translated into an economic damage over the medium term, markets tend to look beyond what’s going on,” says Niladri Mukherjee, head of portfolio strategy, chief investment office, Bank of America Merrill Lynch.
Events like the 9/11 terrorist attacks further exacerbated the weakness in the US economy, which was already suffering from the dotcom crash and equities remained weak for two years. So, it is important to gauge the economic damage first to be able to translate it into forecasts for equity markets, he adds.
The US bank’s base case scenario is that tensions between Russia and Ukraine will escalate. Russia’s economy may suffer in the case of sanctions, with Russian equities already trading at historic discount, valuation-wise. In Europe, there may be headwinds from highly inflationary pressure and higher energy prices, to which Europe is much more exposed than the US.
“But generally, geopolitical actions have had a short reaction in the market and markets tend to revert back to the fundamentals of profit growth and monetary policy after that,” states Mr Mukherjee.
With the decline of the US global leadership, and the rise of China and Russia, the emergence of multiple centres of power should ensure more stability, believes Manuela D’Onofrio, head of investment strategy at UniCredit Group.
Geopolitical risk was much higher in the past, as the world was much polarised, she says. “We are aware of the risk, what the consequences could be, but you cannot take geopolitical risk into asset allocation. Our view on financial assets is always driven by monetary and fiscal policy.”
Geopolitical risks are rising as both the US and China are looking inwards, focusing on their own domestic issues, warns RBC’s Mr Storm. “This leads to an absence of global leadership and increases the potential for more extreme geopolitical issues.”