What to do when traditional diversification doesn’t work

When equities and bonds sell off at the same time — as has occurred this year — investors need to reconsider portfolio construction norms, says Pendal’s MICHAEL BLAYNEY

• Inflation, rates and the Ukraine war are changing the norms of investing
• Equities and bonds both in negative territory this year
• Alternative assets, commodities provide opportunities

INFLATION, the prospect of higher interest rates and the war in Ukraine have altered the investment landscape this year.

“Russia’s invasion of Ukraine is a human tragedy first and foremost,” says Michael Blayney, Pendal’s Head of Multi-Asset.

“We haven’t seen a major war of this nature in our lifetimes. Many are also struggling to come to terms with how to think about it from a market perspective.”

“We went into the war already experiencing high inflation, and the war adds to those pressures.

“Also, central banks around the world had already thrown a lot of stimuli at economies, because of COVID.”

“We’ve ended up with the situation of central banks needing to tighten in a period of geopolitical uncertainty, and that’s a challenge for portfolio construction.”

Government bonds and equities, in Australia and overseas, have fallen in value this year. But the Australian dollar has appreciated, contrary to normal practice in times of crisis when the local currency tends to fall against the greenback.

“The world is a much more difficult place to find diversification and that’s really the theme of the year,” Blayney says. “Normal ways of diversifying aren’t really working at present.”

The critical reason the rules of the past two decades aren’t applying is inflation.

“When you get higher inflation, you tend to see bonds and equities correlate a bit more positively. It means investors need to think about other sources of diversification in portfolios,” Blayney says.

Getting exposure to commodities has been a successful diversification strategy, Blayney says, as has being active in your asset allocation to try and control risk.

“If you are going to move on market conditions, you need to be quite nimble,” Blayney adds.

Pendal’s diversified funds had been overweight growth assets for much of the last couple of years, but have pulled back in the last few months. Pendal’s diversified portfolios are now underweight both bonds and equities.

“That doesn’t mean you want to be underweight forever. There will come a point when it makes sense to reweight towards bonds in the portfolio.

“When there’s an inflation shock, bonds generally feel the heat and then as things settle down, bonds can become a great buying opportunity. Same for equities. We are not there yet but it’s important to keep it in mind.”

Blayney adds that within sectors and geographies there are buying opportunities, hence the need to be active.

“For example, right now Australian equities have better valuations and are a bit more of a safe haven.

“Looking globally there are expensive assets, there are fairly valued assets and there are also some undervalued markets.”

Corporate debt can also provide opportunities with spreads in the US – the difference between yields on a government bond and a corporate bond – around 1.4 per cent. And Blayney says holding funds in cash to take advantage of opportunities is important.

“Our funds have been running a little more in alternative assets than usual, which includes some listed renewables and risk parity and target return strategies that are able to provide alternative sources of returns.

“The alternative asset portfolios have done a really good job of supporting total portfolio returns at a time when equities and bonds haven’t been great.”

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About Michael Blayney and Pendal’s Multi-Asset capabilities

Michael Blayney leads Pendal’s multi-asset team. Michael has more than 20 years of investment management and consulting experience. He was previously Head of Investment Strategy at First State Super and head of Diversified Strategies at Perpetual.

Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.

The team — which also includes Allan Polley — manages our multi-asset portfolios with a focus on strategic asset allocation, active management and tactical asset allocation.

Find out more about Pendal’s multi asset funds:

• Pendal Multi-Asset Target Return Fund
• Pendal Sustainable Balanced Fund
• Pendal Sustainable Conservative Fund

Contact a Pendal account manager here