Macroeconomic conditions are shifting, interest rates and inflation are rising, and geopolitical unrest is making the world less stable. These forces are quickly calling traditional investment approaches into question. Investors need new playbooks to navigate today’s shifting risks and changing opportunities.
Those were the guiding messages from the recent Goldman Sachs Asset Management Investment Outlook for 2023 Media Roundtable. It focused on the portfolio “reconstruction” that needs to occur given “The 5Ds,” or five major themes sparking profound changes in global markets: decarbonization, deglobalization, demographics, destabilization and digitization.
“We (recently) experienced the perfect monetary and fiscal policy storm, with massive liquidity injections, which is very unlikely to repeat,” said Ashish Shah, Chief Investment Officer of Public Investments for Goldman Sachs Asset Management. “Consumer balance sheets came out of the COVID-19 pandemic downturn in a stronger position than ever.”
“The Fed was slow to respond early on to the inflation this perfect policy storm caused, but they pivoted and have since been incredibly aggressive. In one of history’s most aggressive periods of tightening, the Fed went from zero to 4% today, and almost 5% priced into next year,” he said.
“That has been accompanied by financial conditions tightening, which may lead to a recession. That is up for debate because recession is not fully baked in yet, but slowdown definitely is.”
There are investment opportunities in challenging markets, but investors need an active approach to asset allocation.
“This is quite a change from a year ago and more challenging than any time since the GFC,” said Greg Olafson, Co-President of Direct Alternatives for Goldman Sachs Asset Management.
“We think it will persist through next year and offer continued opportunities to find great investments across alternatives platform. Today’s climate plays to the strengths of alternatives by calling upon the advantages of control and influence central to direct investing, contrasted with the indirect approach inherent to public markets. Taking a more hands-on approach allows for proactive value creation and risk management, along with transaction terms negotiation,” said Olafson.
“The indices mask a lot of the volatility in individual assets,” said Maria Vassalou, Co-Chief
Investment Officer of Multi-Asset Solutions for Goldman Sachs Asset Management. “There is ample room for picking winners and shorting losers. High inflation, falling growth and rising interest rates makes investing very complicated. A classic 60/40 allocation does not work.”
“We were a little spoiled, going through a long period since the early 2000s of rising equity valuations and relatively low volatility only interrupted by the GFC. But even then, risks to the
economy increased and central banks stepped in to ease financial conditions. That helped 60/40 performance because bonds became flight to safety instruments and cushioned equities sell-offs.”
“Now, correlations are positive between equities and bonds. That is always the case when going through an environment of rising interest rates, high inflation and falling growth,” she said. “We need to rethink portfolio construction because allocating passively – as done in recent decades – and enjoying rising beta exposures does not necessarily work now, nor will it going forward.”
Bonds are back, but active management will matter.
Asked about the changing role of fixed income in investor portfolios, Mr. Shah said, “Fixed income has played four roles historically: a source of liquidity, a source of income, a tool to
match long-term liabilities and a diversifier. Higher rates and spreads mean bonds are back.
“The question is whether bonds are still a good diversifier – the 60/40 portfolio question so many are asking. It remains one of the most common allocations, particularly in retail portfolios.”
“2021 brought the worst performance of 60/40 portfolios in a long time, disappointing a lot of people with returns around 15%. No one complained about high correlations when everything went up. Unsurprisingly, when everything went down 60/40s caused lots of pain,” Mr. Shah said.
“Income from a 60/40 can be reinvested into whatever asset is cheapest, bonds or stocks. That creates the buffeting power of the 60/40 portfolio, which will remain very much in play. We expect 60/40 to work again, but we do not expect to return to the Goldilocks QE forever regime.”
“Being passive does not work anymore,” Ms. Vassalou commented. “We must be more dynamic because the world is not in equilibrium. We will find the next equilibrium in time, when inflation comes down, and Fed policy stabilizes or reverses owing to a deeper slowdown or recession.”
“During highly volatile markets, there are lots of dislocations, which create opportunities for stock and security selection,” she said. “That helps on the active side, but security selection has to be done when volatility subsides. At peak volatility, as experienced at various points this year, it is much harder to pick stocks. Even when we identify appropriate securities, it is unlikely they will pay off immediately. These opportunities are best harvested once volatility subsides.”
As for liquidity related opportunities from dislocation – such as the rapid Fed moves – Mr. Shah said, “Everything must reprice. Tightening cycles can be scary, but the flip side is they create
some of the best market opportunities for those who are disciplined and willing to take risks.”
Private investing’s hands-on approach allows for more proactive value creation.
Mr. Olafson spoke to the particular challenge private companies are facing. “With rising input prices, slowing growth and declining valuations, the key to successful private
investing will be how general partners and management teams work together to formulate strategies that focus on the ‘old school,’” he said. “This is a back-to-basics environment: how
companies innovate, how they drive productivity, how they extract operational efficiencies.”
“There is probably room for private company valuations to reflect the broader economic environment. The alts are a slow-moving part of the market, but as the cost of capital has
increased, undoubtedly valuations will adjust. We are starting to see that, but private investors should exhibit patience, allowing for value creation in good companies to take hold.” Across Alternative strategies, Mr. Olafson sees the most opportunity in private credit and infrastructure.
On private credit, “This is a very interesting time in a complex world,” Mr. Olafson said.
“Investors are getting paid well these days to be a lender. While uncertain, this environment creates great opportunities for active management of private credit capital, along with much greater dispersion.”
On infrastructure, “The digital transformation is not stopping. It’s a great opportunity. Whether it’s building out fiber capabilities in data center spaces or the application of computing power to the life sciences sector, it will create huge opportunity and innovation. Energy security and the energy transition, including battery storage and renewables, will also be areas of great innovation in the coming years.”
Diversification is the only free lunch.
Ms. Vassalou favors mixing public and private investments. “It is important to pick components from public and private markets investors can access that
maximize expected returns for a given level of risk,” she said. “Public markets can provide good ways to risk manage exposures involved in private markets, both in managing cash flows to produce returns, and providing buffers to help navigate liquidity and volatility episodes.”
Stressing the importance of diversification in portfolio construction, Ms. Vassalou added, “It is important to have uncorrelated assets. Since we just experienced the longest periods of positive correlations between equities and bonds, bonds have not been a good diversifier. Investors need to look for other diversifiers, often provided by alternatives.”
“During the long period that equities kept going up, interest rates were zero or negative and the Fed was providing ample market liquidity. The best thing was to have a beta allocation and enjoy the high returns. Hedge funds and other alternatives fell out of favor, but the current environment makes a strong case for them, from hedge funds to private equity to different sub-categories.”
Ms. Vassalou concluded, “In this very challenging environment, there are also a lot of silver linings and a lot of opportunities. To have staying power with our convictions and reap the results of those investments, we need to really focus on risk management. That will be key.”