Wealth Strategies

Inflation Challenges Conventional Asset Allocation - Pictet

Editorial Staff 21 July 2021

Inflation Challenges Conventional Asset Allocation - Pictet

The Geneva-based private bank examined how price pressures are growing, looking at the role that climate change-related policies have on this, considering that traditional asset allocation approaches need a re-think.

The classic “60/40” equities/bonds split in a portfolio may not be adequate to deal with worldwide higher-inflation, while the costs of tackling global warming could add to price pressures, Pictet Wealth Management predicts.

The Swiss private banking group sought to calculate how investments would be affected by a movement towards a “green” economy as well as how a more inflationary environment might pan out for investors.

Inflation has become more than just a talking point. Massive central bank money printing (aka quantitative easing) and the disruptions caused by the COVID-19 pandemic, have fuelled higher prices. US data issued a few days ago showed that consumer prices rose 0.9 per cent in June from where they were in May, producing a 5.4 per cent year-on-year increase. Core CPI was 4.5 per cent, even when more volatile items such as food and energy were removed. Such figures in the US and other parts of the world have set off alarm bells.

Investors need to re-think how they should guard against the destructive impact of higher inflation, Pictet said. 

“A classic 60/40 portfolio (60 per cent equities, 40 per cent bonds) may be suboptimal at times of higher inflation,” Christophe Donay, head of asset allocation and macro research at Pictet Wealth Management, said. “From a strategic asset allocation perspective, the expected rise in inflationary pressure, in part because of energy-transition policies over the next 10 years, is a further argument in favour of endowment-style investing, ie the multi-asset approach adopted by endowment funds which include a range of real assets (private equity infrastructure, real estate, commodities and gold) that may protect against inflation.”

“As governments and central banks steadily integrate climate-change issues into their policy making, we expect these issues to affect everything from asset-class dynamics to strategic asset allocation and investing styles,” Donay said.

Climate change
“Climate change will be one of the most important externalities hanging over economies and markets. As these are internalised into production processes and consumption patterns to transition to a low-carbon economy, they will impose higher costs on third parties, contributing to higher inflation by a projected 10 basis points (bps) per year over the next 10 years in major economies,” Donay said.  

“Overall, the influence of climate considerations on our long-term return expectations is limited in absolute terms – in the region of ±40 bps for most asset classes, but above 100 bps in the case of some, such as emerging-market equities and gold,” he said.  

Overall, despite the potential downside risks, Pictet’s central scenario is for global growth to “remain solid” over the next 10 years as policymakers increasingly come to grips with climate change concerns, while innovation continues to spread through economies – at a moderate but steady pace, the firm said. 

Asia and other excitements
The bank is relatively sanguine about the Asian economic outlook. 

Dong Chen, senior Asia economist at Pictet Wealth Management, said: “Asia’s economic importance will likely become even more significant in the current decade. In 2019, Asia accounted for 34.8 per cent of world GDP, up from 26.9 per cent in 2009, due to a much higher growth rate. Between 2009 and 2019, over half of the global economic growth was attributable to Asia. We expect Asia’s (ex-Japan) annual GDP to grow at 4.2 per cent by 2031 and account for an even greater share of world GDP over the next 10 years.” 

“China is expected to continue its economic transition, relying less on physical capital and fixed-asset investment (especially government investment), and more on household consumption and services,” Chen said. 

Pictet said “China has been steadily refining its climate goals, with the latest aiming to achieve carbon neutrality by 2060 after hitting a peak in emissions by 2030.”

The bank weighed the boost to growth from large-scale investments in green technologies against the inevitable costs that will be incurred. It reckons that climate-change policies will provide a “modest” 10 bps boost to Chinese annual GDP growth to 4.8 per cent from 2025 to 2030.

The bank said that Chinese government bonds offer more attractive yields than their developed-market peers, helped by the prospect of renminbi strengthening, with expected appreciation of 0.8 per cent a year against the dollar over the next 10 years. 

India’s nominal GDP growth may reach an annual average of 6.5 per cent for the period 2023 to 2031 compared with last year’s forecast of 6.8 per cent, Pictet said, based on a rising working-age population, the current government’s labour laws, manufacturing sector reforms and pro-growth measures, while also taking into account the challenges in implementing structural economic reforms.

The bank predicts a 3.2 per cent annual GDP growth for the period 2023 to 2031 for the “rest of Asia” consisting mainly of South Korea, Taiwan and Southeast Asia. 

“South Korea and Taiwan both face the challenges of a shrinking population that will weigh on public finances and economic growth, as well as the escalating geopolitical risks, given the central role both play in global technology supply chains,” the bank said.

“Southeast Asia will likely benefit from global supply chain migration of labour-intensive sectors out of China, with Vietnam expected to outperform as a major recipient of foreign investment and a growing export-oriented economy in the decade to come, benefiting from its favourable demographic dividend, export-driven and socialist-oriented market economy, as well as heavy investments in infrastructure and education,” it said.

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