By Giordano Lombardo, CEO and Co-CIO Plenisfer Investments SGR (Generali Investments)
The 2023 game is being played in key fields such as inflation and central banks from one side, and geopolitics from the other one. In this scenario, what are the implications for investment strategies? It is necessary to analyze the inadequacy of the 60/40 model.
One of our basic theses is that the traditional diversification model based on the equity/bond pillars (the so-called 60/40 model) is in crisis. This model has held up asset allocation strategies throughout the 40-year phase of falling interest rates, but it does not fit in a phase in which the deflationary process that took hold in the 1980s seems to have wound down.
The year 2022 proved the validity of this thesis, with the stock market and the bond market both in strong decline. This is not to say, of course, that a balanced portfolio cannot outperform in individual years, even in 2023!
In fact, in the bond market, a more acceptable risk/return combination has been reestablished after the 2022 price collapse, although corporate bond spreads still do not discount the levels reached in the past, during periods of global recession or slowdown. In equities, there remain areas of overvaluation that have been only partially corrected (Big US Tech), but in some cases — Europe, Japan, emerging markets — valuations appear reasonable, although not so much so as to provide a robust defense in the event of a widespread recession.
If, however, we start from the assumption that the scenario we’re now facing is characterised by the two elements discussed above — namely financial repression and structural geopolitical instability — the inadequacy of the 60/40 model to address them once again becomes apparent.
In an era of financial repression, the government bond markets of those countries intent on implementing such a policy — namely the major developed countries — should be avoided. In an era of endemic geopolitical instability, on the other hand, riskier assets, such as equities, are more exposed to the resulting increase in market volatility. What’s to do, then?
The first point is that the objectives and priorities of portfolio management change. The main objective becomes protecting the value of portfolios in real terms, rather than seeking the highest returns as in the previous phase (a phase in which market volatility was artificially constrained due to central-bank policies).
Thus, there can be no shortage of commodities/metals (both industrial and precious) as a structural component of the portfolio, despite the fact that the lack of cash flow has in the past often resulted in their exclusion from portfolios as a primary asset.
Second, liquidity (cash) will have to be reconsidered in its traditional role as a risk-free asset: its optionality, in fact, makes it a strategic asset in periods of endemic volatility.
On the other hand, the so-called liquidity premium, which has favoured the heavy reliance on the inclusion of private assets (private equity and private credit) in portfolios, will have to be reconsidered in a structural way. It’s because of the presence of strongly leveraged components in past yields from these asset classes, or that returns are put at risk in the face of rising interest rates. It’s also because in a phase of financial repression and endemic volatility, the strategic value of liquid assets increases structurally, compared to a historical phase of price stability and medium to low volatility. In other words, the lack of mark-to-market valuations rather than constituting a “risk premium” becomes a structural disadvantage. The risk premium has been shredded due to the huge demand for these assets in the past few years, just when volatility would dictate that we need it most, while the disadvantages of non-liquidity are still apparent.
Finally, in the new paradigm of financial repression and volatility, the traditional two-step investment process of asset allocation and stock picking is challenged, precisely because of the difficulty that individual asset classes — traditional and alternative — have in performing their historic roles. A new method is needed, which we have identified as “deconstructing” traditional asset classes (e.g., equity, bonds) in order to “reconstruct” them into uncorrelated strategies deployed according to risk/return objectives.
This is what we have proposed and adopted since the launch of Plenisfer and our first Fund. It is paying off at the moment. There is still a long way to go, and the game to be played out in the coming years will remain complex. The conditions for winning are to be clear on where the game is really being played and what the (new) rules are.
