Uncertainty is endemic, so build portolios
With uncertainty around global macro policy priorities and implementation, and an increasingly volatile, complex and ambiguous world, the diversified multi-asset investment approach becomes indispensable. A portfolio approach to investing is widely regarded as superior to a concentrated exposure for sustained investment performance, because it leverages diversification to manage risk and improve long-term returns. Diversifying across asset classes generates more consistent investment performance across economic regimes, reducing the risks associated with investment decisions based on unpredictable macroeconomic outcomes. By spreading investments across a variety of assets, sectors, or geographic regions, investors reduce the likelihood of significant losses tied to the underperformance of any single investment.
This approach mitigates volatility and downside risk, but also capitalises on the performance drivers and macro conditions underlying the differentiated performance across asset class and over time. While a concentrated exposure may offer high returns if a specific asset performs well, it also subjects investors to steeper losses which can take longer to recoup, making it a less attractive option for most investors seeking sustainable growth.
Diversification across exposures
A parsimonious set of distinct return drivers and risk factors influence asset classes in different ways, so the combination results in a diversified portfolio. The following table sumamrises some of the major asset classes, and their key return drivers (exposures) alongside factors that can be a headwind to performance (risk).
Exhibit 1: Key return drivers and risk across asset classes (macro factors highlighted in red and green)
Source: Bank of Singapore. Note: Drivers marked in green are supportive of discounted cashflows, while red reflects risks of worsening.
For example, (as described in our earlier Uncertainty in the formation of expectations report) equities generally provide returns through dividends and capital appreciation (via multiples expansion, profit margin and revenue growth), levered to actual and expected economic growth, alongside improvements in operating efficiency, market expansion and competitiveness. However, they also carry a higher risk due to market volatility and company-specific factors. Bonds, on the other hand, typically offer stable income through interest payments and are influenced by interest rate changes and credit risk, often serving as a safe haven asset during market downturns.
Commodities, such as copper and oil, are often driven by supply-demand dynamics and can act as a hedge against inflation, especially during high growth periods. Gold can be an even more consistent hedge against inflation, as well as against USD depreciation and acute geopolitical risk. Alternatives – which cover a broad range including hedge funds, private markets, infrastructure and real estate – are influenced by growth factors, but also by manager selection, deal and vintage risks, reflecting the heterogeneity of projects and investments in each Alternatives vertical.
Scenario analysis using a factor-based model of return and risk attribution can help to illustrate how the same catalyst exerts a differentiated impact across asset classes. The following exhibit illustrates the hypothetical returns associated with two distinct shocks: a rise in market implied inflation expectations (measured as a 100bps increase in the spread between 2Y US Treasuries (UST) and 2Y Treasury Inflation Protected Securities (TIPS); the blue bars), and a spike in market risk (represented as a 10% increase in the VIX index; orange bars).
Exhibit 2: Scenario analysis: Possible impact on select asset classes from rising US inflation expectations or a spike in US equity volatility
Source: Bank of Singapore, using Blackrock Aladdin
In the former case, a move higher in inflationary expectations can drive negative returns in UST as yields move higher. It is a headwind for credit markets as well, but the carry in credit markets acts as a cushion to returns and results in a small positive performance. In contrast, the inflation shock can cause investors to favour real, growth-oriented and inflation-hedged assets, leading to stronger demand and price appreciation in both equities and commodities.
The impact of higher overall market uncertainty on the same set of asset classes could not be more different. A spike in the VIX Index (a barometer for equity volatility), reflecting greater market uncertainty, has an outsized negative effect on equities and the High Yield (HY) markets. USTs are mostly immune with negligible returns. Credit asset classes are hit, with the overall market uncertainty pushing spreads wider which results in negative performance; this is more pronounced in lower rated HY where spreads widen more than Investment Grade (IG), and in the longer duration, more spread-sensitive, Developed Markets (DM) IG segment.
Understanding distinct drivers and risks helps investors strategically allocate assets to balance growth potential and mitigate risks across varying market conditions.
A brief history of macro regimes
The above scenario analysis shows how different factor exposures leads to variability in asset class responsiveness to a common catalyst. Different so-called “factor loadings” explain why performance across asset classes varies within a macro regime, making it essential for investors to understand these dynamics.
To assess the impact of the macro environment on asset class performance, we first build a macro regime framework to partition history into distinct growth and inflation episodes, then compute various asset class returns conditional on the different macro regimes.
The following two exhibits illustrate the cornerstone to our regime framework: US inflation (represented by YoY changes in the monthly US PCE deflator) and economic activity (using the Conference Board’s monthly composite of coincident indicators, which comprises four cyclical economic data series which reflect employment, household income, industrial activity, and business revenues). We divide inflation and activity each into low, medium, and high outcomes. The thresholds that determine the respective ranges are based on the Federal Reserve’s (Fed) 2% inflation target (in the case of inflation), and long-run GDP growth (in the case of activity), un-adjusted for trend.
Exhibit 3: US inflation (monthly, YoY changes, Jan 1970 – Oct 2024)
Source: Bank of Singapore
Exhibit 4: US growth (monthly, YoY changes, Jan 1970 – Oct 2024)
Source: Bank of Singapore
Before reviewing market performance considering different macro environments, it is worth taking a moment to review the historical macro record and highlight any generalisable trends through the present day.
Over the last 50 years, the US economy has undergone significant changes in both growth and inflation dynamics. High inflation was a defining feature in the 1970s (expressed by the red shading in Exhibit 3), driven by the OPEC oil embargoes and loose monetary policy, but moderated to lower ranges starting in the 1990s. Also in the 1970s, the economy experienced uneven economic growth, marked by intermittent periods of deep contractions followed by growth rebounds (Exhibit 4, alternating red and light blue bars). “Stagflation” emerged to describe the simultaneous occurrence of high inflation and stagnant economic growth.
In subsequent decades, vastly different macro outcomes transpired: while this is evident in the above exhibits’ changing color sequence over time, it is even more apparent in the following summary of decadal growth and inflation average levels and their variation (which uses the same color schemes as the growth/inflation exhibits). We use the exhibits to describe history.
Deregulation, tax cuts and increased defense spending supported growth in the 1980s, while aggressive monetary policy reigned in inflation to the 4% level by the middle of the decade, which is 140bps lower on average compared to the 1970s.
The 1990s experienced steady and impressive economic expansion, underpinned by increasing globalisation and productivity gains. Inflation remained low, typically below 3%, due to stable monetary policy.
In the 2000s, growth was highly uneven, with the decade beginning and ending with two financial crises. The financial crisis in 2008-2009 led to a sharp contraction in GDP, but recovery began in 2009. On average, due to the Great Recession at its end, this decade posted the lowest average growth in the sample, with high variation. Inflation was moderate, averaging 2.3% over the decade, but concerns arose over deflation during the financial crisis.
The 2010s were characterised by steady growth, but trending lower, driven by modest productivity growth and fiscal restraint following the Great Recession. Structural changes such as deepening globalisation and digitisation, kept prices subdued, with average inflation reaching multi-decade lows.
Exhibit 5: US growth and inflation (YoY changes, Jan 1970 – Oct 2024)
Source: Bank of Singapore
In terms of broader trends up to the present, inflation peaked at over 13% in 1980, and moderated to far lower and fairly stable levels (averaging 2.3% in the 1990s, all the way to 1.5% in the 2010s) until recently, when inflation spiked higher during Covid-19 and has settled to slightly higher levels compared to the pre-Covid era.
In the case of activity, the trend has moved slightly lower, with the only instance of high growth (signified by light blue area) during the post-Covid reopening period. Red areas correspond with technical economic recessions (1970, 1973-1975, early 80s, 1990, 2001, 2007-2009, 2020) as well as mid-cycle slowdowns. Recent data show activity comfortably eluding a mid-cycle slowdown (last couple of years are firmly stable and in the green).
Macroeconomic context matters
So, what do these different macro environments – combinations of growth and inflation – imply for asset prices? The following exhibit arrays asset class performance within the four macro regimes that prevailed over the last 20 years for which we have a full complement of data (note that some macro environments such as high growth/high inflation (classical “Overheating”) or low growth/high inflation (“Stagflation”) episodes did not occur). To facilitate comparison, asset classes are tagged to a unique color.
The ranking of asset class performance varies significantly across the different macro regimes and the full sample. It is worth highlighting three examples.
Exhibit 6: Asset class performance in different macro regimes, ranked in descending order (monthly YoY returns, Jan 2003 – Oct 2024)
Source: Bank of Singapore.
Note: Assets are arrayed in descending performance within the given macro regime (average returns in percent are given in parenthesis). Monthly YoY returns from 2003-2024 (longest period available across all asset classes). Only the 4 macro regimes (of 9) which reach our minimum 4% sample size are shown.
Firstly, within these selected asset classes, equities (as represented by the S&P 500 Index) has ranked as the strongest performing asset class over the last 20 years, as well as during solid non-inflationary good growth periods goldilocks-type regimes. They performed relatively well, though less so, during medium growth environments with high inflation. But recessions posed challenges, and the S&P 500 Index’s performance during these times was lower on a relative basis compared to other regimes, and versus other asset classes. Broadening this out, other equities behave similarly: posting strong relative performance in good growth environments and returning poor performance during recessions.
Secondly, in contrast to equities, USTs (alongside IG bonds) are the outperformers during recession and the underperformers during growthy times. They are poor performers in high inflation environments. Performance across UST and IG bonds tend to cluster together, reflecting the common dominance of interest rate risk.
Lastly, gold and commodities do well under the high inflation regime. Gold shines brightly during recessions (while commodities perform poorly). Both face significant headwinds in a goldilocks environment where their hedging properties are less sought and valued.
Exhibit 7: Asset class and sample portfolio worst macro regime performance vs average returns (monthly YoY returns, Jan 2003 – Oct 2024)
Source: Bank of Singapore
The variation in performance of any asset class across different macroeconomic regimes is significant. Diversifying across asset classes helps to generate more consistent investment performance across economic regimes, reducing the error associated with incorrectly forecasting the macro environment. One way to demonstrate the value of diversification is to compare unconditional regime-agnostic performance (i.e., average return) against the worst regime outcome (i.e., our definition of downside risk) for a sample portfolio and individual asset classes (see Exhibit 7).
The dotted line reflects a measure of return per unit of downside risk for the sample portfolio. Asset classes to the right exhibit a superior return adjusted for downside risk, compared to the sample portfolio. The vast majority of asset classes reside to the left of this line, reflecting a worse trade-off between return and risk.
The multi-asset portfolio improves the risk adjusted return profile of most standalone asset class investments significantly. For instance, it achieves more than double the return of DM IG, for roughly the same amount of downside risk. Portfolio returns are higher than Asia ex-Japan equities, with a third its downside risk. Plainly, the diversified approach is the dominant strategy in most cases.
Exhibit 8: US growth and inflation regimes (9 growth/inflation combinations are colour coded, monthly, Jan 1970 – Oct 2024)
Source: Bank of Singapore
The need for diversification is amplified by increasing macroeconomic uncertainty. The last exhibit paints the nine different regimes we track, from 1970-2024. Extended high inflation periods characterised the 1970s and 1980s; a goldilocks era of good growth and moderate inflation – ideal for risk assets – prevailed in the 1990s into the GFC. The decade post-GFC was a US goldilocks macroeconomic era largely of solid growth and low inflation.
Since 2019, exogenous downside shocks to growth, extraordinarily accommodative policy, its sharp reversal to fight the inflationary spike, have produced a quick succession of changes in macro regimes. The pandemic and supply chain disruptions have challenged the balance between growth and price stability. Uncertainties around policy priorities, their implementation and ramifications, increase the likelihood of persistence in macro volatility. Ultimately, a well-diversified, multi-asset portfolio is better positioned to weather uncertainty and achieve more consistent returns across a wide expanse of economic outcomes, well telegraphed or otherwise.
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