Portfolio construction: What if we're wrong?

As we have written over the years, one of the central tenets to our investment beliefs is the acknowledgement that more things can happen than will. In simple terms this means that there are many possible outcomes for markets but only one comes to be. As asset allocators this encourages humility in how we set up our portfolios, and leads us to continually ask ourselves ‘What if we’re wrong?’

In our feature article, we outlined our views on the outlook for the global economy and markets for 2020. While we end up with a central view, it is the output of a range of scenarios with differing probabilities that need to be factored into the portfolios we design. The base case is that we do not see a recession being imminent, which means that companies will continue to grow earnings, albeit at a lower rate. Therefore, we believe that maintaining growth exposure will deliver positive returns. We recognise that current valuation levels are not cheap and therefore we prefer a neutral exposure to equity markets rather than going overweight. We do not foresee a significant rise in interest rates with central banks tending to favour accommodative monetary policy.

So, what else could happen and more importantly, how would our portfolios react to these other environments and how might we respond?

Market correction driven by economic slowdown

The most obvious way we can be wrong is if concerns over the extent of an economic slowdown become significant enough to drive stocks lower. In this scenario it’s likely that those companies whose valuation depends on expectations for significant future growth will be impacted the most. We have attempted to mitigate this risk by tilting our portfolios to reflect a quality bias, where the active managers we employ focus on companies with strong cash flow and low earnings volatility. In addition, although we think the return outlook for bonds is much lower than historic returns, we would expect to see a flight to safety in a slowdown environment and bonds would help support the overall portfolio return.

Rise in inflation

Global inflation expectations remain below long-term trends and Central Bank targets but could surprise to the upside. If this were to happen in a gradual manner it would be viewed as optimistic in the short term and supportive of growth assets, but a rapid rise would give cause for concern and likely lead to interest rate rises. From a portfolio perspective, equities would likely benefit in a benign inflation environment. We also have exposure to real assets, gold and inflation linked bonds, which would help if inflation moved above longer-term Central Bank targets.

Rise in interest rates

Any expectations for a rise in interest rates could be seen as positive or negative for portfolios. It is the pace of changes in expectations and likely Central Bank reactions that will drive markets. From a fixed income perspective, we have tilted our portfolio to shorter duration assets to mitigate the risk of rising rates, but we have not eliminated all the duration exposure as we recognise the potential source of portfolio protection that it can offer in market drawdowns.

It is highly likely that there will be unexpected events in 2020, but as we have displayed for nearly a decade, we are confident in the ability of our investment approach to withstand these challenges and continue to help our clients achieve their objectives.