Despite the best efforts of central banks, advanced economies are way out of balance. A well-diversified and actively managed portfolio provides protection in an unsettled environment.
Why are economies unbalanced?
The early years of this decade have shown us how anything can happen – pandemic, war, food shortages. In 2023, supply-and-demand conditions in the major advanced economies remain out of balance. For example, unemployment rates are very low and wage growth is strong. The result? Inflation is high, and developed-world interest rates continue to rise. While many analysts are predicting decreases in both by the end of the year, there are no guarantees.
This stands in stark contrast with the prior decade, which was characterised by low interest rates and inflation rates that barely breached 3%. Things ticked along nicely in that relatively balanced world; most people who sought employment were able to find it, and central banks increased interest rates only periodically and by small amounts, which helped the public with things like taking out loans or mortgages. Investors benefited from steady returns.
But then Covid came crashing through economies, shutting them down for months on end. When real life returned, markets were euphoric, and people went out and spent money, pushing the stock market and consumer prices higher. Inflation rates rocketed throughout most of the world, so central banks, including the US Federal Reserve, Bank of England and European Central Bank, embarked upon an aggressive interest-rate-raising programme, trying to bring inflation down by increasing the cost of borrowing from a bank. It didn’t work as quickly as they’d hoped, and soon the world was beset by not only high inflation but drastically elevated interest rates compared with only two years earlier.
Where do we go from here?
We’re now in an environment in which growth is likely to be stifled; while recessions have thus far been mostly avoided, many analysts expect they could come to pass even though inflation is expected to drop through the rest of this year.
In the US, the insolvency of First Republic brought the banking sector back to the fore and raised questions about whether crisis has actually been avoided. Turmoil in the financial services sector, which by nature is more sensitive to interest-rate rises, could serve to accentuate that imbalance so many economies are currently facing.
Innovative investing
The imbalances that are still present in economies and markets are likely to lead to high volatility in the future. We believe an investment approach that emphasises innovation, to generate as much impact as possible from each investment in the portfolio, is the best way to maximise your chance of success in this environment.
A portfolio of well-researched holdings that is carefully diversified by both asset class and region can reduce the risks associated with these economic imbalances. Additionally, pronounced economic and market volatility typically leads to big differences in the returns of each asset class. For example, uncertainty in economic and central bank policy typically leads to greater variation in the returns of different industries and companies. In these conditions, skilled active management can improve returns.
In the US and Europe, factors like wage pressures and exposure to interest rates will increase the importance of identifying company-specific opportunities or risks in the short term. This will be compounded by the profound longer-term changes that are underway, including the worldwide transition to a lower-carbon economy and extraordinary changes in computing-related technologies, e.g., microelectronics, quantum computing, and artificial intelligence.
While these major technologies are reshaping business and markets, high interest rates, inflation and widespread volatility are more familiar challenges. In fact, these conditions are an expected part of long-term investing, and collectively, investors are compensated for exposing their capital to these risks. Familiar or not, we have the capability and expertise to guide our portfolios through atypical and changeable markets and we’re applying an investment style that gives us important flexibility in times like these. Actively managing these opportunities and risks to find the right mix of investments is the way forward in an unbalanced world.
Investment View: Why we think actively-managed portfolios are the right choice
The global economy is undergoing a fundamental change. Investment strategies that have worked well in recent years might not be right for the future.
The world has become increasingly complex since the start of the 2020s, and as a result, the investment strategies that generated steady returns in the recent past may not be as successful today. To navigate this new, more volatile landscape, we’re adopting an active approach to constructing our portfolios.
Passive vs. active investing
Before we look at active portfolio construction, let’s consider the advantages and disadvantages of active and passive investing. A passive investment style essentially involves mimicking an index like the FTSE 100 by buying the same securities – like stocks or bonds – in the same proportions. This approach works well in in periods with buoyant bond and equity markets, as was seen in the last decade.
As passive approaches require less time and research, they tend to be lower cost. Furthermore, as they only trade when the index they follow undergoes an update, tax costs associated with buying and selling are lower as well.
Flexibility, however, is where a passive style can pale in comparison with active management; passive investing is typically focused on major indices, so exposure to certain niche markets or investment assets may be limited. Active management, on the other hand, offers the ability to tailor portfolios to individual client needs and allows exposure to a broader range of asset classes and sectors. If you’re looking to invest with an ethical angle, an active approach is probably best, since it enables investors to scrutinise and even influence companies to achieve sustainable outcomes. This active approach, however, is typically pricier due to the effort involved in researching and decision-making.
Staying active while keeping costs down
Deciding on an active investment style doesn’t have to mean you’re ‘all in’. While a traditional active approach relies on the portfolio manager’s skills at selecting securities that could outperform the market, a semi-active approach borrows elements of active and passive investing: typically, a fund will follow an index but buy more of particular companies or bonds that meet certain criteria (called 'factors’). This rules-based approach can save on fees; since it doesn’t require deep analysis of each security, it involves less time and fewer analysts.
A new investment landscape
A pandemic, war in Europe, food and fuel shortages, and the rise of China as a major world economy have delivered a fresh set of challenges to investors. Markets and indexes themselves have changed too: in the US, for example, the dominance of mega-cap tech companies has reshaped certain stock markets. Tech giants like Apple, Amazon, Microsoft and Google now account for a substantial portion of the market, and so major indices are heavily influenced by their performance.
This concentration has led to imbalances and increased volatility. An active management style seems most appropriate for this kind of development, which requires managers to seek opportunities outside that dominant sector to avoid overexposing investors to these enormous companies.
In short, we believe the increasing complexity of future market conditions calls for a dynamic and adaptable approach – but which method is best?
The perfect blend
Happily, there’s no need to commit to a single investment style. The ability to blend all three approaches – and decide which style is best-suited for each market – can provide diversification benefits, reduce the likelihood of short-term underperformance and provide more reliable outcomes. Distinct from active investing, this is called ‘active asset allocation’ or ‘active portfolio construction’ – a toolkit that provides the choice and flexibility to manage whatever life throws at your portfolio.
The information and opinion contained in this Monthly Commentary should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by atomos. Any expressions of opinion are subject to change without notice. Past performance is not a reliable indicator of future results. Investing involves risk and the value of investments, and the income from them, may fall as well as rise and is not guaranteed. Investors may not get back the original amount invested.