Asset Allocation and Diversification
As an investor you need to think carefully about the effects that economic cycles have on the assets you are either invested in or thinking of investing in, even if you choose to hold cash, and the interrelationships of those assets. In investing language this is know as Asset Allocation, which is underpinned by Modern Portfolio Theory (MPT) i.e the investment theory developed by Harry Markowitz in 1952, that espouses diversification and the allocation of capital to different asset classes (portfolio construction), with the aim of maximising expected returns for a given level of risk. In effect, portfolio diversification is closely linked to the movement of economies through economic cycles, which in-turn effects the price/value of asset classes. This cause-effect relationship between economic cycles and asset classes is depicted diagrammatically below.
Historically the 60/40 portfolio was the go to diversification strategy. The efficacy of that strategy has been determined by the low correlation between its two broad components (asset classes): public equities and bonds. In accordance with MPT, if that low or negative correlation holds, an underperformance of either asset class in the portfolio (equities or bond) would be offset by the uncorrelated performance of the other asset class.
Recent global macroeconomic and geopolitical events signal very interesting implications for Capital Formation, an important foundational component that underpins investment decisions.
Capital markets in essence exist in service of capital formation, and ever since the late 18th century have become increasingly interconnected, where causes and effects are often non-linear. Post the second world war the U.S. established dominance of global trade, with the Dollar earning the title "Global Reserve Currency." As such, for the majority of the 20th century the Fed, and by implication the U.S., had overweight influence re: global macroeconomics and geopolitics.
This dominance is however showing signs of weakening, partially due to the domestic context in the U.S., specifically where it is in its long-term debt cycle (see the video below, which explains the long-term debt cycle and its importance), and partly because of other global macroeconomic factors e.g. the growth of China, India, South East Asian Countries, etc.
Recently the BRICS cohort of countries (Brazil, Russia, India, China and South Africa) overtook the G7 cohort of countries (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States) as it relates to contribution to global GDP. BRICS now contribute 31.5% vs. the G7, which contributes 30%. The resulting narrative, increased speculation about the U.S.'s decline as a hegemonic power. Similarly, a recent increase in inflation in Japan, which has been low since the 90s, is stoking speculation that Japanese savers in aggregate would start to sell U.S. government debt (Japan is the largest holder) in favour of debt issued by the Japanese government, in effect exacerbating the U.S. decline.
Given the aforementioned non-linear cause and effect relationships, it is very difficult to determine with any level of credible precision how this will play out, albeit that history provides some clues (reference the link to the long-term debt cycle video above). We do however think that these events are catalysing tectonic shifts in capital markets, including the underlying infrastructure that facilitates capital flows. As time progresses these changes will have major implications on capital formation and by implication will impact your investment decisions.
For your Information: This paper speaks to the historic changes of capital markets and capital formation. Beyond this paper we will start to dive deeper into the changes that we are seeing, and will share a perspective about our envisaged impact of those changes on investment decisions.
Capital Markets, Capital Formation, the acceleration of an interconnected world since the late 18th century and the changes in capital markets and capital formation in effect have resulted in the dramatic growth of different asset classes beyond traditional public equities and bonds i..e the global growth of Real Estate, Commodities,Venture Capital, Private Equity, Private Debt, Hedge Funds, Art, Crypto etc, across different markets. As such, the relevance of the traditional 60/40 portfolio is being brought into question, especially given uncorrelated returns of some of these asset classes to traditional asset classes. This paper is a fair, albeit narrow, examination of the relevance of the 60/40 portfolio. Makes for interesting reading. The graphic below highlights the low correlations of "Alternatives" to public equities, bonds, or both.
An investor today has at his/her disposal, in theory, a variety of assets to construct a diversified portfolio to maximise returns for a given levels of risk. Sadly, in practice this is not broadly accessible however, implying that risk mitigation associated with higher recession probabilities is diluted.