Insight Investment

Executive Summary

This note focuses on two key issues that affect our asset-allocation thinking:

1. The extent to which the post COVID environment has changed the outlook for growth, inflation, and the longevity of business cycles. We conclude:

• Compared to recent decades, we see greater uncertainty around both growth and inflation. The latter is important because the absence of pricing pressure over the past 20 years has given policymakers the flexibility to respond to growth shocks with stimulative policy, to micromanage or extend the business cycle. We assume big government is here to stay, but even allowing for higher budget spending, the current starting point for monetary and fiscal balances means there is less scope to counterbalance further negative growth shocks in the future.
• Given the current level of bond yields and, arguably, elevated valuations of some equity markets, this a) argues for lower return expectations, and b) questions the performance expectations for previously successful strategies such as the ‘balanced 60/40 style’ portfolio. These are both valid concerns. However, in our minds it re-enforces the need for a dynamic approach to asset allocation with the flexibility to embrace a broad opportunity set, including a range of alternative strategies.
  
  

2. We review our cyclical asset-allocation framework to assess its suitability to tackle the likely challenges ahead. We conclude:

• The key drivers of asset class performance appear stable through time. For equity markets growth is a dominant force, for FX and bonds, real rates matter most. For commodities, inflation is important. The interaction between inflation and risk assets is not as simple as is often assumed. Real interest rates are important, again when viewed in conjunction with growth dynamics.
• Our growth and inflation regime framework allows us to assess how asset class behaviours differ in various states of the world going back over 50 years. The clarity and consistency of our findings suggest the framework is still likely to provide a solid starting point for asset allocation. Finally, we show how this framework can help identify alternative diversifiers when the role of government bonds is less certain than in the past.