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Bonds are back - but alternatives never left

27 Apr, 2023 | Return|

The uncertain market backdrop and higher volatility seen in 2022 left many questioning the effectiveness of the traditional 60/40 portfolio. Investors increasingly looked to other areas of the market for diversification, namely alternatives. With the economic backdrop seeming more positive, cash and bonds are now looking more attractive again.

Alternatives, however, still remain relevant and offer protection, diversification and opportunities to investors. For Square Mile’s latest ‘A Spotlight On’ series, our panel argued the case for alternative strategies. We were joined by:

Bonds vs alternatives

A major argument for alternatives from the panel was that while bonds may be providing diversification again after a turbulent 2022, that’s not always the case. Bonds and equities can move together, so another protectionist method is always required. As a result, a well-managed alternative strategy should continue to play an important role in a balanced client portfolio as it can offer a different degree of capital protection and element of diversification. That’s particularly important in times of volatility and when markets become more challenging.

A prime example of such a time is when there are market dislocations, as seen in 2022. Alternatives can take advantage of these instances and can move dynamically to limit downside. This is crucial given that bond and equity correlations are not constant, but instead reflect the macroeconomic environment. For that reason, alternatives can help clients protect against unexpected bumps in the road. They’re a shock absorber against macro and market-related difficulties.

Alternatives and inflation

Inflation and rising interest rates are two of the current market-related difficulties causing investors concern - far more than just over a year ago. A benefit of alternatives, with a nimble investment approach, are the broad array of opportunities which provide alternative managers with many levers to pull to deliver positive absolute returns. Adjusting to an inflationary environment is, therefore, more easily achievable as those levers allow alternative teams to pivot as and when it's required.

For instance, even though supply chains are starting to normalise again against the current backdrop, inflation will likely stay above targets set by central banks in the near future. By conducting a stock-by-stock assessment, including engaging with company leaders to understand approaches to pricing, the impact of high inflation on profit and losses can be found. Differentiating between the companies that have strong pricing power versus those whose earnings will struggle is then possible.

Alternative opportunities for the future

The panel discussed the areas they see as possibilities for investment over the next twelve months.

At J.P. Morgan Asset Management, with their wider macro view that looks at long-term secular themes as well as short-term cyclical dynamics, they see cloud computing and healthcare innovation as an exciting space to be. For the latter, there’s potential for the delivery of many technologically innovative solutions which will meet unmet needs - particularly in robotics or drug development.

For the team at Fulcrum Asset Management, they are repositioning their portfolio given their likely scenario of significant outflows from the banking sector. Currently, they are running at lower risk, and they have reduced their commodities exposure quite significantly, however they still have some precious metals positions. To them, the FTSE is looking inexpensive at the moment - which they believe to be just one example of some good value available, thanks to lots of negative sentiment priced into the market.

For Stefan Gries and the team at BlackRock, they see returns potentially coming from pent-up demand for travel, which has remained strong. Specifically, they are exploring investments in aerospace companies. With China reopening, consumer spend in luxury goods such as footwear, spirits and apparel could be an opportunity. In Europe, one for their short books will be highly leveraged businesses, with weak balance sheets, that are operating in competitive industries and exposed to refinancing risk. Finally, they anticipate an earnings normalisation in some sectors - particularly logistics and freight forwarding, where earnings will come down because capacity is coming back.

Alternatives: the dynamic diversifier

Ultimately, one key theme ran through all our panellists’ answers. Not only do they have a broader array of potential investments within their strategies, they also have the space to take advantage of those opportunities, especially in times of high volatility. It means that alternatives can provide protection in portfolios, particularly in tough times - even when fixed income moves in line with equities.

WATCH PANEL DISCUSSION

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