Marketing communication – For professional investors only

Francois Collet, Deputy CIO for Fixed Income at DNCA, shares his perspective on the importance of nimbleness and true diversification in a volatile environment.

Francois Collet, do fiscal dominance, deglobalization, geopolitical tension, resource constraints, and the green transition mean investors need to embrace a new outlook?

All of these are novel concerns that investors should be paying attention to. Fiscal spending was not an issue coming out of 2008 and governments embraced austerity; now we have some governments that are embracing de facto «modern monetary theory» policies – running wartime deficits when unemployment is near record lows. That’s a huge shift.

Deglobalisation is a relatively new phenomenon that should continue. Geopolitical tensions, especially in the Middle East, are at their highest in a generation or more. And the green transition will continue – against a backdrop of growing resource constraints. There’s also the issue of secularly tighter employment markets, at a time when productivity has not been increasing a lot. That’s a recipe for higher wage growth and core inflation.

Given this, we do think that investors need to embrace a new outlook. While disinflation should continue for the foreseeable future, a lot of this is because of base effects which can’t continue forever.

In fact, we would not be surprised to see inflation settle at a higher level than before and for inflation volatility to remain higher, and you are already seeing this in some indicators like long-term inflation expectations.

This last part is important: companies and investors can get used to inflation perhaps settling at a moderately higher level, but what they haven’t had to contend with for a generation is sharp swings in prices, which affects asset correlations and future spending plans.

Where previously the assumption was that a portfolio of stocks and bonds, and maybe some real estate was diverse enough to provide a decent level of mitigation against market shocks, 2022 offered a cogent reminder that different and diverse aren’t necessarily always the same thing. As a result, investors will have to be much more agile than before.

What could this mean for assets? Is higher asset price volatility here to stay if inflation volatility remains high?

Yes. Higher inflation volatility is particularly damaging for several reasons. First, if central banks are serious about wanting to keep inflation stable at around 2 percent – and we believe they are – then their reaction function will have to be more aggressive, more often, to tame inflation when it rises much above 2 percent. That’s obviously bad for nearly all assets as they drain liquidity and tighten financial conditions like 2022.

Second, if inflation is less certain and more volatile, bond investors are likely to demand a higher term premium for holding longer-dated bonds, while yields are likely to spike higher on occasion.

In very simple terms, this could weigh on government bonds, steepen yield curves and hurt equities - whose valuations are discounted against bond yields and the «risk free rate». Equity valuations in some countries like the US are not cheap and may be susceptible to a de-rating if we see inflation settle higher or yields spike like we did in 2022 – particularly interest rate sensitive, longer duration stocks like technology.

We also saw this briefly in 2023, when the US government’s aggressive fiscal policies saw the term premia spike, hurting equities. So, in 2022 we had an oil price shock, and in 2023 we had fiscal issues. Both remain risks.

So, investors need to think about true diversification. The 60/40 portfolio and the idea that stocks and bonds will always be inversely correlated is a relatively new phenomenon. If you look back throughout history, and especially when governments have targeted the real economy and economic growth, as they are now, this has typically not been the case. It’s a reality that investors should embrace or be open-minded to.

Will this favour active investors who can embrace flexibility and real diversification?

We think so. The «great moderation» could end up being a historical aberration. But we believe this could be a boon for those who can take advantage of it.
We think traditional fixed income will continue to struggle and may not offer the ballast or defense that it once did, and which investors still need. This is why we take a highly diversified approach to our fixed-income portfolios – and have expanded our range of absolute return funds.

With the right expertise, volatility can be turned from a foe to a friend. The 40-year bond bull market may be ending; but with the help of strategies like duration management, arbitrage, relative value etc, we believe a new bull market for nimble and intelligent investors is just beginning.

Written in March 2024.

Additional Notes
Marketing Communication. For professional investors only. Past performance is not indicative of future results. All investments involve risk, including the risk of capital loss. The provision of this material and/or reference to specific securities, sectors, or markets within this material does not constitute investment advice, or a recommendation or an offer to buy or to sell any security, or an offer of services. Investors should consider the investment objectives, risks and expenses of any investment carefully before investing. The analyses, opinions, and certain of the investment themes and processes referenced herein represent the views of the portfolio manager(s) as of the date indicated. These, as well as the portfolio holdings and characteristics shown, are subject to change. There can be no assurance that developments will transpire as may be forecasted in this material. In Switzerland: This material is provided by Natixis Investment Managers, Switzerland Sàrl, Rue du Vieux Collège 10, 1204 Geneva, Switzerland or its representative office in Zurich, Schweizergasse 6, 8001 Zürich.

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