In the penultimate instalment of Investment Week’s ‘Higher for longer’ series, which examines the effect persistently higher interest rates are set to force on various corners of the market, we dive into multi-asset, an investment style which feels the impact across the majority of assets.
Back in September, the Federal Reserve, the Bank of England and the European Central Bank opted to hold rates, a move the ECB continued yesterday (26 October).
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While central banks are prioritising bringing inflation down to their 2% targets, the higher for longer environment will undoubtedly impact asset classes.
However, Tom Kynge, deputy fund manager at Sarasin & Partners, told Investment Week that such an backdrop could be a “helpful development” for return-seeking multi-asset funds, as higher yields on cash and bonds “provide a reasonable alternative to equities after the post-Global Financial Crisis TINA period”.
He noted, however, that higher yields also raise economic risks, which are likely to result in elevated volatility.
This week, the yield on US 10-year Treasury bonds exceeded 5% for the first time in 16 years, sparking debate about the outlook for the fixed income sector.
As a result, Kynge argued “extra attention must be paid to tactical allocation decisions and hedging strategies”, as timing and risk management are “more important now than they have been in the last decade”.
Alex Harvey, senior portfolio manager and investment strategist at MGIM, pointed out that multi-asset funds have not been “immune” from the last few years of higher interest rates, but he argued they have “more levers to pull”.
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He described 2022 as “the perfect storm” noting that “higher rates dragged pretty much everything lower”.
“Unless you held gold or cash, there were few places to hide,” he said.
But Harvey added that multi-asset funds have the ability to benefit from diversification, which is intrinsic to their blended design.
He explained: “Now that the ‘reset’ button has been hit, bonds and yielding assets can once again start to provide some ballast to the higher risk assets in multi asset portfolios, such as equities.
“If there is a risk off event, or a more aggressive slowdown in global growth, there is room for yields to compress. That should translate into better diversification benefits for multi-asset portfolios as cross asset correlations fall. Other things being equal this should deliver an improved risk-return profile.
“If rates stay at current levels for a prolonged period, investors will clip a healthy yield while they wait. In that scenario, total returns at the portfolio level will be driven much more by the income than capital valuations, although capital values on riskier assets and bond proxies could come under pressure if rates rise meaningfully higher from here.”
Harvey also noted that floating rate instruments could benefit from the higher for longer environment as their coupons reset higher each quarter, which could impact capital values, but strong returns could be achieved by higher quality asset-backed paper.
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“Cash has become increasingly alluring as the higher rate narrative has extended, but the reinvestment risk – the risk that rates fall, and you are not able to reinvest at today’s rates in the future – is very high today,” he said.
“Cash is rarely king for long.”
Lindsay James, investment strategist at Quilter Investors, and Sarasin’s Kynge, agreed the environment would be more challenging for equities, as companies will face a higher cost of capital.
James argued the companies which are not dependent on the strength of the economy will be “highly prized”, alongside those with strong balance sheets and the ability to pass on higher costs to consumers.
However, she added the “net impact” of higher rates is yet to fully reach companies – which are likely to post weaker corporate earnings – as well as consumers.
Kynge added that discount rates for future cash flows will likely be impacted due to higher yields at the ten-year maturity, potentially leading to lower valuations as a result.
James and Kynge both highlighted alternatives as an area of interest in the higher for longer environment, with the former noting that “hedge funds stand to benefit from the divergent returns likely within equity markets”.
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She said infrastructure and renewables trusts “should be well placed” as they have “varying degrees of inflation-linkage in their cash flows”.
Although their discount rates have been impacted in the last few months, she argued that current share prices “appear to neglect the likely revenue uplifts that are also likely in a high rate/high inflation environment”.
Kynge also pointed to real assets, which are likely going to be supported by the high rates and high inflation environment, alongside commodities, which “tend to do well during inflationary cycles”.
Overall, James and MGIM’s Harvey said the higher for longer backdrop was likely to favour fixed income in a way not seen for many years.
“While equities for now broadly carry the risk of earnings downgrades”, value-oriented and dividend-producing companies will always “offer opportunities to active investors”, James said.
Harvey added: “We think that today more than ever you need to have a diversified portfolio, and the multi-asset investment class is the best way to navigate the multitude of risks that face investors today.”
