Newton¹ Real Return portfolio managers Aron Pataki and Lars Middleton think we’re in a new regime for investing – one that requires them to field their best attacking and defensive players.

Key points

• We are moving into a new investing environment in which monetary support is less likely.
• Traditional asset diversification strategies could be less effective than they were in the old regime.
• Investing in global themes affords the Real Return team a long-term perspective.
• Building a multi-asset portfolio is like picking the players in a football team.
   

Newton’s Real Return portfolio managers are fielding their best ‘football team’ to face what they view as the formidable opponents of high asset class volatility, low expected equity market returns and volatile boom-and-bust cycles.

Portfolio managers Aron Pataki and Lars Middleton observe we are at the end of the long disinflation trade characteristic of the era since the global financial crisis. They add the current environment of higher inflation and higher-for-longer interest rates is potentially unfamiliar territory to many investors and one in which policymakers are less likely to engage in monetary stimulus to prop up capital markets.

Reflecting on the past decade, Pataki says: “Every time there was a problem in the world, policy makers had the ability to step in and stimulate because inflation wasn’t a problem. This period covered the career of many people in the financial industry, so many people have been conditioned to believe business cycles are prolonged. If inflation is sticky, it will be much harder for central banks to step in, stimulate and elongate business cycles for as long as we have been used to.”

New approach

This means the starting point for investors today is potentially less attractive than at the start of the previous cycle, says Pataki. When it comes to asset prices, he thinks structurally high inflation and interest rates could cap equity market returns, push up the equity risk premium and, ultimately, move up the term premium on government bonds.

“The reason is because investors should demand a higher term premium on government bonds in a more volatile environment,” he says. “That doesn’t mean we can’t have rallies but the refrain of the last couple of decades that everything goes up pretty much all the time and every dip is a good buying opportunity, may not work as well going forward.” 

As such, Pataki thinks traditional asset diversification strategies could be less effective than before. He notes in 2022 the crumbling of the low correlation relationship between bond and equities prices that had been a feature of the low stable inflation regime of the previous two decades. “That relationship formed the basis of many risk management policies in the multi-asset space for a generation of investors – we must go back to before 1998 to observe a persistent positive correlation between equities and bonds^2.”

Picking the right team

Pataki says the Real Return team’s approach to building a multi-asset portfolio is like selecting the line-up for a football team. “Different players play different roles in different parts of the field,” he says.

The Real Return strategy has two component parts: a core of return-seeking assets to drive long-term returns (return-seeking core), and a layer of stabilising assets consisting of diversifying assets and direct protection strategies (stabilising layer). The team has flexibility to tweak the balance of these two parts to match its view of the world.

“When it comes to the return-seeking core, or ‘attackers’, we view it as important to have some core compounders with strong thematic support in areas where we think there is a runaway for growth. We also think it is important to have inflation hedges, companies with pricing power and stable cashflow generation profiles,” says Pataki. “When it comes to the ‘defenders’ we think it is important to have volatility dampeners that can produce non-correlated returns.”

Taking the analogy further, Middleton says: “In the core of the portfolio we have equities as ‘strikers’ and alternatives as ‘defensive midfielders’. In terms of stabilising assets, cash is the ‘goalkeeper’ and the ‘back four’ is the likes of government bonds and gold. We see it as trying to structure a portfolio that can work in a multitude of scenarios and isn’t reliant upon just one asset working.”

Themes

Middleton says investing through a thematic lens gives the team a long-term perspective. “It allows us to step back when we see short-term volatility and swings in asset prices and gives us a view on which businesses are likely to be long-term winners,” he adds.

A theme the Real Return team thinks could yield opportunities is ‘great power competition’. Pataki says the fragile geopolitical backdrop is likely to increase uncertainty and volatility. He thinks the situations in the Middle East and in Ukraine could shift governments towards more spending which Pataki suggests could benefit defence contractors.

Pataki also thinks artificial intelligence (AI) has the potential to revolutionise many industries, as it could offer corporates and the broader economy significant scope to boost productivity. “It’s a theme we have leaned into,” he adds.

Elsewhere, decarbonisation and the green energy transition are creating opportunities, according to Pataki. “It is clear to us decarbonisation efforts and the continued urgency to reach energy self-sufficiency is going to shift governments toward more spending. Companies leaning into this transition could benefit,” he adds.

Generally, Pataki thinks companies’ and governments’ capex could pick up as we move out of the old era that was characterised by disinflationary forces. “It is going to be an extremely different environment in which governments could spend more in certain areas which could provide tailwinds for equities with the right characteristics.”

Middleton concludes: “We think the environment ahead may be different to the one we have seen historically. So, what has worked in terms of tools and techniques may not work on a go-forward basis. It is important therefore to have a broad toolkit and full flexibility to navigate and mitigate volatile markets and we think right now there is a compelling opportunity for the strategy.”

The value of investments can fall. Investors may not get back the amount invested. 

¹Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Management (Luxembourg) S.A. (BNY MFML) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA, BNY MFML or the BNY Mellon funds.

²Newton, Bloomberg. May 2024