By Asbjørn Trolle Hansen, head of the Multi Assets Team at Nordea Asset Management
Investors have experienced several periods of severe market turbulence since the global financial crisis – most notably the European sovereign debt crisis—the ‘taper tantrum’—and the initial stages of the Covid-19 pandemic. Fortunately, the sharp drawdowns proved on each occasion to be temporary, and the bull run for stocks and bonds ultimately resumed.
With numerous asset classes performing positively in unison since 2009, most multi-asset approaches – including the traditional 60/40 portfolio – largely delivered on long-term investor return objectives. In addition, due to the largely sanguine environment during the 2010s, portfolio diversification – which is perhaps the primary attribute of a multi-asset solution – was only infrequently put to the test.
However, as turmoil swept through markets last year sparked by aggressive central bank action to tame inflation; traditional diversification methods were regrettably found wanting. Historically, fixed income has been the investor instrument of choice to mitigate equity market downside. But many investors were left with nowhere to turn when both stocks and bonds sold off aggressively in tandem during most of 2022. By the end of the year, bonds had suffered the worst year in history, while most major equity markets remained firmly in the red. In our view, traditional diversification has for some time not been able to protect investors to the extent it once did. The ‘correlation perfect storm’ we witnessed last year was a painful reminder of this.
The limits of traditional diversification
If traditional asset class diversification has reached its limits, investors can look to adopt differentiated approaches to balancing risk – such as the opportunities available in alternative risk premia. We believe investors can capitalise on both cyclical and anti-cyclical return drivers from a broad and diversified set of 30 risk premia spread across strategy types and asset classes. For example, as an alternative to traditional government bonds in recent years, we have utilised areas such as currency-related risk premia. Attractively valued currencies can provide pleasantly defensive characteristics – the simplest example being the Japanese yen versus the euro. While risk assets have enjoyed a strong start to 2023, bouts of heightened turbulence are likely to become a feature of the market environment for the foreseeable future, as central banks continue to hike rates in an attempt to cool inflation and the damaging war in Ukraine rages on.
Stability is set to return to the spotlight
Despite these challenges, it is not all doom and gloom for investors. At the beginning of 2022, expectations for equity beta and duration risk premia were 4.5% and 0.3% per annum, respectively. However, because of the events of last year, this has now increased to 6.3% and 1.4% per annum. We are particularly optimistic on Stable/Low Risk Equities, which have demonstrated an ability to perform through periods of heightened volatility – as well as periods of elevated inflation. As is commonly known, equities offer the highest return potential within a multi-asset strategy, but the asset class is also the greatest source of risk. Therefore, it makes sense to identify companies displaying a greater degree of solidity in stock price, earnings, dividends, EBITDA and cash flow than the broader market.
In our view, stable, high quality and attractively valued companies – which historically offer more resilient earnings – are naturally in a far better position to navigate through this continually challenging economic backdrop. In addition, we look for companies exhibiting pricing power, which have the ability to pass on inflation price increases. This is a valuable characteristic in the current climate. Also, Stable/Low Risk Equities continue to offer a 1.4% earnings yield premium versus the broader market. This is an incredibly attractive building block for portfolios in the months and years to come.