- Against an increasingly challenging geopolitical backdrop, exacerbated by the war in Ukraine, we are entering a new market regime, characterised by higher inflation and prolonged volatility. Economies are looking to make significant investments in strategic areas such as food, energy and defence, with a lower priority being attributed to cost and achieving maximum efficiency.
- In this more precarious, inflationary environment, bonds and equities are more likely to lose ground in tandem, meaning that a traditional 60:40 portfolio will struggle to work as effectively as previously.
- Investment outcomes are likely to require a highly selective approach. There may be a premium on relatively secure profits and dividends, and perhaps less willingness to indulge in significant hopes of future growth alone.
- The assets that we believe merit a place on the field include commodities, equities in the defence and health-care sectors, and alternatives, counterbalanced with long- volatility positions, derivatives protection, gold, cash and ‘safe-haven’ US-dollar exposure.
Since the inception of the Real Return strategy more than 18 years ago, a topic of frequent debate is where we stand in the business cycle. This question is particularly pertinent in the context of expected returns, given our stated performance aim is to meet a cash +4% target.
Today, we are at a critical juncture, amid a shift away from an era characterised by years of falling inflation and low interest rates, interventionist, asset-price-friendly central banks, abundant liquidity and low volatility. It is right to call this an era rather than a phase as it has lasted for more than 20 years and has led to a ramping up of asset prices across a broad spectrum, with speculative bubbles forming in parts of the economy such as the housing market and private equity – areas that have started to look increasingly vulnerable as the tide goes out.
We are now entering a new regime, further accelerated by the pandemic, where the competition between great powers is playing out in front of our eyes: a number of different battles are being waged from trade rivalry to technology wars, to security and resource competition. Moreover, domestic political developments are driving more fractious geopolitical relations.
Rather than observing a rerating of assets in a disinflationary world, we are now witnessing a derating of asset prices in an inflationary environment. The implications of this higher-inflation regime are that central banks now have less flexibility to stimulate economies through rate cuts and liquidity injections, leading to higher volatility and shorter business cycles than we have been used to over our investing careers. Traditional asset diversification is likely to be less beneficial and harvesting beta less effective, as we anticipate that broad equity-market returns are likely to be more modest owing to lower-trend growth over the coming months and years.
From efficiency to resilience economics
The spectre of war has sent profound shock waves across the world, but most notably in Europe, which has found itself facing conflict on its doorstep. This has led economies to consider making significant investments in strategic areas such as food, energy and defence, with a lower priority being attributed to cost and achieving maximum efficiency. Indeed, this change is already underway. We recognise this as a shift from efficiency economics to resilience economics, which is creating inflationary headwinds as an increased focus on reshoring and greater local sourcing drives prices upwards.
Considering this regime shift through a portfolio-construction lens, there are profound implications. Over the last two decades, the negative correlation of bonds and equities has been a clear feature of a stable, low-inflation regime. By contrast, periods of rising inflation (such as the 1970s) indicate that bonds and equities are likely to be positively correlated, meaning that they will lose ground in tandem during an inflationary regime. This means that a traditional 60:40 portfolio may struggle to work as effectively as previously. Indeed, the 10-year US-Treasury yield has broken out from its 40-year trend, with yields moving sharply and decisively higher.
In this new regime there will be additional capital-expenditure needs: the desire for military and diplomatic influence over territories and values will lead to increased defence expenditure, while increasing resource competition will necessitate control of strategic resources to boost national advantage. This will include increased investment in the energy transition, while access to the right commodity at the lowest cost will determine economic competitiveness. Technology will increasingly become a weapon as major economic forces, notably the US and China, seek to ‘decouple’.
In such a precarious environment, evidenced by many of our investment themes (such as the growing competition between great powers and China’s increasing influence), outcomes are likely to become more binary, requiring a highly selective approach. There may be a premium on relatively secure profits and dividends, and perhaps less willingness to indulge in significant hopes of future growth alone. We have already seen an unravelling of many high-valuation, long-duration, cash-flow negative technology stocks, with the Nasdaq losses greatly outpacing those of the S&P 500 index.
The assets that we believe merit a place on the field include commodities, equities in the defence and health-care sectors, and alternatives, counterbalanced with long-volatility positions, derivatives protection, gold, cash and ‘safe-haven’ US-dollar exposure. There will be times when we may choose not to allocate to a particular area of the market or asset classes, while a more concentrated, higher-conviction position in others may be warranted in recognition of the divergence of fortunes between sectors and companies.
Although it is not our base-case thesis that the current inflation spike becomes a more permanent feature (owing in part to thematic influences such as demographics and the debt burden), we do believe that inflation will settle at higher levels over the medium term and acknowledge the need for inflation- hedging assets in the portfolio.
A role for alternatives
A fitting case study would be the renewables holdings which sit within the Real Return strategy’s alternatives allocation. These companies incorporate inflation assumptions in their net-asset-value calculations, currently reflecting the sharp rise in inflation over recent months. Similarly, within the strategy’s infrastructure holdings, contracts are often indexed to inflation and are long-term in nature, enhancing their attractiveness in an environment of spiralling price rises. The strategy’s current c.20% weighting in alternatives is a recognition of the role that these assets can play amid the current regime shift. Coupled with our focus on companies displaying pricing-power characteristics, as well as those with income-generating properties (a valuable attribute when capital appreciation is harder to come by), we believe they provide the portfolio with an armoury to face a more inward-looking, hostile world, albeit one not devoid of investment opportunities.
The need to be nimble
Managing uncertainty requires a flexible approach and the change of regime that we have witnessed underscores the need to be nimble. As thoughtful asset managers, we can seek to take advantage of volatility to generate returns, and find opportunities created by dislocations to select investments where the return potential is higher than before. We do not believe that the future will resemble the past and consider that a combination of catalysing forces ranging from geopolitical tensions, climate change and a less-accommodative central-bank backdrop are bringing about a fundamental change in the fabric of our investing world. Real Return is designed to have the latitude and asset-class flexibility to navigate such an environment: indeed, we believe that now is precisely the time that it can fully draw on its long experience of allocating capital in challenging times.
Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.
Newton Real Return strategy – key investment risks
- Performance Aim Risk: The performance aim is not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for returns to vary significantly.
- Currency Risk: This strategy invests in international markets which means it is exposed to changes in currency rates which could affect the value of the strategy.
- Derivatives Risk: Derivatives are highly sensitive to changes in the value of the asset from which their value is derived. A small movement in the value of the underlying asset can cause a large movement in the value of the derivative. This can increase the sizes of losses and gains, causing the value of your investment to fluctuate. When using derivatives, the strategy can lose significantly more than the amount it has invested in derivatives.
- Changes in Interest Rates & Inflation Risk: Investments in bonds/money market securities are affected by interest rates and inflation trends which may negatively affect the value of the strategy.
- Credit Ratings and Unrated Securities Risk: Bonds with a low credit rating or unrated bonds have a greater risk of default. These investments may negatively affect the value of the strategy.
- Credit Risk: The issuer of a security held by the strategy may not pay income or repay capital to the strategy when due.
- Emerging Markets Risk: Emerging Markets have additional risks due to less-developed market practices.
- Liquidity Risk: The strategy may not always find another party willing to purchase an asset that the strategy wants to sell which could impact the strategy’s ability to sell the asset or to sell the asset at its current value.
- Shanghai-Hong Kong Stock Connect and/or the Shenzhen-Hong Kong Stock Connect (‘Stock Connect’) risk: The strategy may invest in China A shares through Stock Connect programmes. These may be subject to regulatory changes and quota limitations. An operational constraint such as a suspension in trading could negatively affect the strategy’s ability to achieve its investment objective.
- China Interbank Bond Market and Bond Connect Risk: The strategy may invest in China interbank bond market through connection between the related Mainland and Hong Kong financial infrastructure institutions. These maybe subject to regulatory changes, settlement risk and quota limitations. An operational constraint such as a suspension in trading could negatively affect the strategy’s ability to achieve its investment objective.
- CoCos Risk: Contingent Convertible Securities (CoCos) convert from debt to equity when the issuer’s capital drops below a pre- defined level. This may result in the security converting into equities at a discounted share price, the value of the security being written down, temporarily or permanently, and/or coupon payments ceasing or being deferred.
- Counterparty Risk: The insolvency of any institutions providing services such as custody of assets or acting as a counterparty to derivatives or other contractual arrangements, may expose the strategy to financial loss.
- Investment in Infrastructure Companies Risk: The value of investments in Infrastructure Companies may be negatively impacted by changes in the regulatory, economic or political environment in which they operate.
This is a financial promotion. These opinions should not be construed as investment or other advice and are subject to change. This material is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those securities, countries or sectors. Please note that holdings and positioning are subject to change without notice. Issued in the UK by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorised and regulated by the Financial Conduct Authority, 12 Endeavour Square, London, E20 1JN and is a subsidiary of The Bank of New York Mellon Corporation. `Newton’ and/or the `Newton Investment Management’ is a corporate brand which refers to the following group of affiliated companies: Newton Investment Management Limited (NIM) and Newton Investment Management North America LLC (NIMNA). NIMNA was established in 2021 and is comprised of the equity and multi-asset teams from an affiliate, Mellon Investments Corporation.