For most of the past decade, markets have been in a regime of falling interest rates and low inflation. This environment has favoured the traditional ‘60/40’ (equity/bond) portfolio – an approach that typically relies on equities for growth and bonds for diversification during periods of market stress, or negative correlation between equities and bonds. This changed in 2022. Central banks raised rates rapidly to counter high inflation. As a result, fears over slowing growth led to equities and bonds falling in tandem, despite typical expectations of bonds helping to counter equity market volatility.
Equity markets have moved on from the initial inflation and rates stress, partly driven by a handful of US technology companies and solid economic growth. However, bonds have continued to face a challenging market backdrop. Rate-cut expectations have been pushed further into the future, with the last mile of bringing down inflation proving challenging. Despite this, the absolute strength in equities has led to a strong rebound in ‘60/40’ portfolios.
Equity markets have moved on from the initial inflation and rates stress, partly driven by a handful of US technology companies and solid economic growth. However, bonds have continued to face a challenging market backdrop. Rate-cut expectations have been pushed further into the future, with the last mile of bringing down inflation proving challenging. Despite this, the absolute strength in equities has led to a strong rebound in ‘60/40’ portfolios.
Correlation between equities and bonds
Equity markets are now much more concentrated by region, sector and individual company. The US is 63% of the MSCI AC World. Information technology is the single largest sector at 23%, with five businesses making up 14% of an index that contains over 2,800 companies. At the same time, long-term valuations are not particularly compelling – the S&P 500 trades at 22x forward earnings, well above long-term averages. There’s little margin for error if earnings disappoint.
Conversely, bond yields are significantly more attractive than in the past decade and can benefit from a rate-cutting cycle. So they are a better starting point for diversification. But unless inflation comes down to targets that allow rate cuts, investors might need to temper their expectations that falling yields will help to offset weaker equity markets
Understandably, investors are asking for better ways to construct resilient portfolios. In doing so, they’re increasingly looking for more diversified sources of growth and income. Specifically, portfolios that might generate attractive long-term returns while providing resilience during periods of market or economic stress. In our view, multi-asset solutions that are diversified across a range of assets can help support the desire for more diversified and flexible portfolios.
Conversely, bond yields are significantly more attractive than in the past decade and can benefit from a rate-cutting cycle. So they are a better starting point for diversification. But unless inflation comes down to targets that allow rate cuts, investors might need to temper their expectations that falling yields will help to offset weaker equity markets
Understandably, investors are asking for better ways to construct resilient portfolios. In doing so, they’re increasingly looking for more diversified sources of growth and income. Specifically, portfolios that might generate attractive long-term returns while providing resilience during periods of market or economic stress. In our view, multi-asset solutions that are diversified across a range of assets can help support the desire for more diversified and flexible portfolios.
Diversified assets
We invest in traditional and alternative asset classes in an unconstrained and flexible way. In doing so, we try to offer a strong return potential, reliable long-term income and resilience across different economic scenarios.
We look for fundamentally attractive long-term investments, with differentiated risk and return drivers. This includes traditional and alternative asset classes. We believe this helps to reduce volatility in the short term and lessens the reliance on any one asset class to deliver income and returns – a factor that we think is particularly important in today’s market environment. Over the past 10 years, we’ve seen significant growth in the breadth and depth of alternative opportunities that are available in daily traded, liquid forms. These assets potentially offer diversification benefits for portfolios (see graphic).
A rich opportunity set that can reduce reliance on equities and bonds
Additionally, while our portfolios are positioned for the long term, the outlook for individual asset classes will ebb and flow as risks and returns evolve. We take an active approach to asset allocation, looking to identify the most attractive risk-adjusted returns. We also use abrdn’s expertise in traditional and alternative asset classes, meaning our portfolios can benefit from a broad range of insights and experience.
For most of the past decade, we’ve seen little long-term value in bonds, which reflects low expected returns. However, interest rates have risen sharply and bond yields are now more compelling. Over time, we expect central banks to cut rates back towards neutral, supporting bond returns. However, as we’ve seen in recent months, the path to this will not necessarily be smooth. And for credit, while total income may be compelling, credit spreads are pricing in a benign default environment, which leaves a limited margin for error.
While we see selective opportunities in traditional asset classes, we remain cautious about relying on them alone to generate income and growth.
Instead, we see several long-term opportunities in a much broader range of asset classes with attractive risk and return characteristics across market environments
Outlook
Based on our long-term expected returns framework, we currently see less value in listed equities. This primarily reflects higher starting valuations, with US equities looking particularly expensive on multiple long-term valuation metrics. And while there may be reasons for optimism about factors such as the benefits of AI on productivity growth, we also recognise there are multiple downside risks for equities.For most of the past decade, we’ve seen little long-term value in bonds, which reflects low expected returns. However, interest rates have risen sharply and bond yields are now more compelling. Over time, we expect central banks to cut rates back towards neutral, supporting bond returns. However, as we’ve seen in recent months, the path to this will not necessarily be smooth. And for credit, while total income may be compelling, credit spreads are pricing in a benign default environment, which leaves a limited margin for error.
While we see selective opportunities in traditional asset classes, we remain cautious about relying on them alone to generate income and growth.
Instead, we see several long-term opportunities in a much broader range of asset classes with attractive risk and return characteristics across market environments
- Infrastructure assets that offer capital growth potential and that benefit from long-term stable cashflows that are often inflation-linked. We believe current valuations are compelling on a long-term basis and have the potential to generate strong risk-adjusted returns.
- Local currency emerging market bonds, which potentially offer attractive returns and diversification benefits.
- Floating-rate asset-backed securities, which offer a materially higher credit spread versus similarly rated corporate credit. In our view, they also provide structural protection from defaults over time.
- A variety of special opportunities – or assets with often idiosyncratic return drivers. For example, debt that is backed by healthcare royalties or precious metals royalties. Then there’s litigation finance, where performance is based on the merits of a legal case rather than economic growth or inflation.
The information provided in this article is for general informational purposes only and does not constitute professional financial advice. Always consult with a qualified financial advisor before making any investment decisions.