The need to rethink portfolio asset allocation during periods of economic uncertainty

For the majority of investors, achieving capital preservation, return on investment, and a predictable income stream is paramount. Traditional investments often fall short in turbulent markets and uncertain economic conditions marked by high interest rates, high Inflation and high market volatility, prompting the need for diversification into alternative assets. Private commercial real estate debt (CRED), as a subset of the private credit (also referred to as private debt) sector can offer investors an uncorrelated alternative to traditional investments. With its potential to provide stable, risk-adjusted returns with debt security, CRED represents a valuable addition to diversified, defensive investment portfolios.

The current economic climate, characterised by war, de-globalisation, inflation, and high interest rates, is causing traditional approaches to portfolio construction to be questioned.

These approaches, which have been successful in the past for investors seeking portfolio diversification benefits, may not be as effective anymore for a key reason:

• High correlation between shares and bonds.

The environment for both inflation and interest rates has fundamentally changed. While increasing an allocation to bonds was previously an easy way to reduce portfolio risk and improve portfolio diversification, that is no longer the case.

Historically, when share prices rose and more people bought to capitalise on the growth, bond prices typically fell due to lower demand. Conversely, when share prices fell, investors often turned to traditionally lower-risk, lower-return investments such as bonds, so their demand and price would increase off the back of this increased demand. This negative correlation provided a natural hedge against portfolio volatility. It’s one of the reasons they complemented each other in financial portfolios — bonds provided the stability and balanced out the volatility of the share market. However, in recent years, the correlation between these two asset classes has pivoted, and an increasingly positive correlation has become commonplace. The increase in inflation that started in May 2021 made market conditions that much more challenging.

Supply chain disruptions, a tight labor market, the war in Ukraine, and strong economic growth fuelled a perfect storm to push up inflation from its previously stagnant levels. As long as the outlook for inflation and interest rates remains uncertain, the diversification benefit from bonds will probably remain muted, therefore placing traditional asset allocation strategies into question.