For a long period, the investment backdrop had been characterized by low nominal interest rates, together with low and stable inflation. Central banks had lowered rates such that borrowing costs in most of the developed world ended up close to, and in some cases below, zero. Meanwhile, levels of sovereign debt, already enlarged in the years following the 2008 global financial crisis, were further expanded by the Covid pandemic to reach heights not seen since the second world war.

As governments were borrowing, their central banks were helpfully buying up their debt and growing their own balance sheets through quantitative easing and lowering interest rates. A rising tide lifted all boats; the prices of equities, bonds, property and most other asset classes rose strongly. In this environment, the value of portfolio diversification was frequently questioned, as it appeared to add little material benefit to the ultimate outcome.

Since the world began to emerge from the pandemic, it has become increasingly clear that a number of inflection points have indeed been reached. Consumer price inflation rose to 40-year highs across developed economies in 2022, and central banks aggressively raised interest rates in an attempt to contain it. Furthermore, the US Federal Reserve, among other central banks, began the process of balance-sheet reduction. These conditions led to one of the worst bond market sell-offs in a generation, with classic diversification again proving unhelpful as equities fell in tandem.

While rates of headline inflation have more recently been falling, and financial-market participants have been pricing in a series of interest-rate cuts, we believe that, now these inflection points have been reached, investors are facing a very different regime and are unlikely to see a return to the benign conditions of the previous decade.

Navigating complex structural change

It is not just monetary boundaries that have been reached or redrawn; economies are being influenced by several broad structural trends, with the result that the financial-market conditions of the future are likely to be very different from those with which investors were familiar in the decade and a half following the global financial crisis.

Among these key trends are growing geopolitical tensions. For several years, the US and China have each been implementing restrictions against the other on the import and export of key goods and minerals. Elsewhere, the war in Ukraine and conflict in the Middle East have been leading to heightened volatility and causing disruption to established trading patterns.

Facing the future

Investors are contending with a complex backdrop. A world that is less connected, less stable geopolitically, and facing major structural challenges, is likely to be one that remains volatile and is potentially more inflationary.

In this environment, different investors face their unique challenges.

Defined contribution pension plans are likely to be the dominant savings vehicle of the future for many developed economies. Increasingly they seek access to more diverse assets and are entering a new phase of innovation. Having helped members grow retirement savings, they are now actively considering how to help them manage those savings most effectively in retirement.

With individuals increasingly reliant on investment outcomes over many years of retirement, the role of asset management has rarely been as personally impactful.

Endowments and foundations are concerned about the effect of persistent inflation both on their charitable works and their investment portfolios.

Elsewhere, as markets have experienced the effects of unconventional monetary policy, many sovereign wealth funds and other governmental and supranational organizations have been reassessing their asset allocation.

In order to meet their specific goals and challenges, we believe it is more important than ever for investors to take a future-facing approach that is equipped for the world as it is and will be, not an approach that is founded on outdated assumptions from the past.

Although benchmarks can be a useful measure to compare asset managers’ performance, by their nature they are anchored to what has already taken place.

In an environment where the future looks very different from the past, a benchmark may not be the optimal starting point for portfolio construction.

For example, as a result of the recent AI frenzy, the S&P 500 index is today dominated by the mega-cap ‘magnificent seven’ technology stocks and has become a major bet on companies which, while they may have high-quality business models, may lack the sustained underlying revenue growth to fully justify their lofty valuations.

While history may not repeat itself, a look back at previous cycles suggests that market leadership can change dramatically. Internet and telecommunications stocks, for instance, formed the dot-com bubble in late 1999, but did not lead the recovery when the market finally found its bottom in 2003.

To give a more personal example, during this period I was a young portfolio manager looking after the account of an insurance company. I had been cautious about the equity market and actively reduced exposure to technology ahead of the crash.

However, I only had discretion to reduce the equity weight by around 5% from the benchmark allocation and the portfolio still had a large equity market exposure. After three years, and a 50% decline in the equity market, the insurer was forced to sell over £10bn (around US$13bn) of equities at the bottom of the market and demutualize in order to avoid financial collapse.

I handily beat the benchmark that I had been set, but given the circumstances there was no inclination to thank me.

Unlocking tomorrows investment opportunities

When we think about how we can unlock opportunity for our clients, we see the starting point not as a measure that wasn’t designed to meet their goals, but as those goals and challenges themselves. If we properly understand the context our clients face, we believe we can deliver the outcomes that allow them to get to the right place.

The Covid pandemic and the Ukraine war are strong reminders, if we needed them, of the extreme unpredictability of real-world experience. That is why we do not build portfolios based on a point forecast of the future, because we know that, as a minimum, our best estimate of the future will be wrong in some details.

Instead, our active, multidimensional and engaged approach allows our investment teams to build portfolios based on multiple possible futures, and we try to ensure that clients’ objectives can be achieved in the most probable futures, and exceeded in the more benign possible futures, while trying to build in some protection from adverse futures.

If, as we contend, we are now in a more uncertain period where the overall market will not reliably deliver returns, we believe an investment approach which exploits an unusually wide and innovative range of inputs in its idea generation may be increasingly relevant. This is the foundation of Newton (a BNY Mellon Investment Managements's firm) multidimensional research platform.

Naturally, a key component of our global research team’s work is fundamental, in-house analysis, but the team also delivers valuable insights through thematic, investigative, geopolitical, credit, responsible investment, and private-market research.

As we seek to model future scenarios and selectively extract relevant information from historical data, our research also encompasses rigorous quantitative capabilities. We believe that by looking at investment prospects from all relevant angles, our analysts and portfolio managers are equipped to make better investment decisions for our clients.

MC310-07-05-2024 (6M)