Investors’ Outlook: Traversing risky terrains

Weathering risky terrains

April served as a reminder that geopolitical tensions could swiftly disrupt portfolios. Investors have woken up to geopolitical risks and the fact that while many ponder the job market, interest rates, and inflation, the dreaded proverbial Black Swan could come from outside the macroeconomic context.

Iran’s first-ever attack on Israel marked further escalation in the Middle East, with investors apprehensive over the prospect of a broader conflict in the region that could draw in the US. All the while, the war in Ukraine grinds on, with Russia planning a late spring or summer offensive¹, and investors have had growing concerns over tensions between China and Taiwan. It’s also a historical election year that is likely to be a divisive one in the US.

The CBOE Volatility Index, known as VIX², has been inching higher this year, reflecting a rather slow awakening to the abnormally high geopolitical tensions and fragmentation, oil prices creeping higher, as well as reemerging inflation fears. These worries carried over into a sell-off in global equities.

At the same time, the traditional 60/40 portfolio – long revered as a cornerstone of diversified investment strategies with its blend of 60 percent equities and 40 percent bonds – stands at a crossroads. The classic portfolio strategy took a historic hit in 2022, and it’s worth asking what its future looks like and whether structural shifts in the markets mean that harvesting long-term growth while seeking protection from short-term volatility will require a rethink. How can we best shield ourselves from the drawdowns markets will likely face in the future? Are traditional fixed income allocations in need of review? For instance, might there be a good reason why spreads of investment-grade credit and high-yield bonds aren’t wider? Perhaps they reflect not only the healthy state of companies’ balance sheets but also the G-7 nations’ bloated debt levels. We may well see 60/40 portfolios reducing government debt allocation as investors seek better sources of risk mitigation.

Considering we’re in a period of record-high prices for everything, from cocoa to crypto and gold, seeking alternative assets to stay well-protected may seem like a challenge. Adding liquid alternative asset classes to portfolios, like catastrophe bonds, can serve as solid diversification and a buffer for various outcomes in geopolitical events or turbulent markets. Even commodities, which most would regard as highly cyclical and volatile, can deliver a good degree of inflation protection and provide a source of return without exposing investors to outsized risks. Since the beginning of 2022, the maximum drawdown in the Bloomberg Commodity Index of almost 30 percent isn’t far off that of 10-Year US Treasuries, which most people still see as a risk-free asset. What’s clear is that the simple bonds and equities-only portfolio of our parents’ generation won’t be fit for the purpose of our children’s generation

In this Investors’ Outlook, we dedicate extra space to an early analysis of the upcoming US presidential election, provide a closer look at what the escalation in the Middle East means for commodities, and detail our asset allocation.

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