The principle of diversification must be “reimagined” in a shifting economic and geopolitical climate, according to MLC Asset Management chief investment officer (CIO) Dan Farmer.
While noting that the lead-up to the end of the year is typically characterised by a brighter mood, Mr Farmer assessed that the world is currently in a “tense and troubling situation”.
“Ukraine’s suffering continues, and there are new horrors in the Middle East. Discussing the financial market implications of such events – when lives are being lost – risks trivialising them. Nevertheless, we believe it’s responsible to share our thinking,” he said.
The “great economic fear” of the current situation in the Middle East, Mr Farmer suggested, is in relation to the risk of conflict spreading well beyond Israel and Hamas.
“A wider war involving Iran and its allies, for instance, would likely send the oil price skyrocketing, at least in the short term, which would make central banks’ fight against inflation even harder, and squeeze households and businesses more,” he said.
But Mr Farmer said there are question marks hanging over the potential for elevated oil prices, since high prices encourage new supply – eventually leading to weaker prices – and results in consumers and industry cutting back or substituting their consumption.
Turning to the US, he said that recent developments, including a spike in jobs growth in September, are dampening expectations that interest rates may ease any time soon.
Reports suggest that 2023 may rank as one of the worst years for US corporate bankruptcies in over a decade. Almost half of all publicly-traded companies in the US are unprofitable, which Mr Farmer said leaves them vulnerable to the impacts of higher rates.
“If interest rates remain high, companies will need to devote a larger share of their revenue to cover higher interest expenses as they will find themselves refinancing at higher rates, which does not augur well for the economy or investment markets,” he explained.
“Clearly, for financial market bears, there’s no shortage of data to justify pessimism.”
Summing up the overall situation for investors, Mr Farmer quoted the famous line from The Wizard of Oz: “Toto, I’ve a feeling we’re not in Kansas anymore”.
“‘Kansas’, for investors from the 1980s to about two years ago, was a world epitomised by structural falls of inflation and interest rates, and the implementation of market-friendly policies by centre-right as well as centre-left governments across many parts of the world. Strong asset market returns were one result,” he said.
“The recent past has emphasised how far we have moved from that world. Inflation is stubbornly resistant despite the great pace at which central banks have raised interest rates. Free-market ideas, characterised by globalisation, are becoming lonely, and regulatory and protectionist impulses are gathering strength, in part because of anxieties over wealth inequality.”
In Mr Farmer’s view, what worked for investors in the past four decades is unlikely to work in the future, leading to his call for a reimagining of diversification. He suggested that making portfolios inflation-resistant should be top of mind.
“Investing broadly, whether through passive or quasi-passive strategies, proved to be a cost-effective way of accessing strong equity markets returns,” he said.
“However, with prospective share market returns likely to be more challenging, active-management and good stock selection, with the ability to identify companies with pricing power, will come to the fore.”
Mr Farmer said that private markets are expected to attract even more attention as a source of potentially strong returns beyond those available from listed equities.
While traditional fixed income asset values have been hit hard by rising rates, he said that their future return potential is now seen as being more attractive than in the past.
Additionally, Mr Farmer identified opportunities in private credit due to the asset class’s ability to provide attractive yields and diversification benefits.
He also highlighted unlisted infrastructure as an inflation-resilient investment but warned that investors need to be cautious due to significant competition in the space with a need for purchase price discipline and careful asset selection.
“There’s no time to be lost in configuring portfolios to make them fit for the new era,” Mr Farmer concluded.
