#Market Strategy — 28.09.2022

Stormy Markets Call for an Alternative Approach

Arnaud Tellier, CEO, APAC at BNP Paribas Wealth Management

Increased recession risk and volatile global markets will continue to challenge traditional investment strategies as we navigate the rest of 2022.

Soaring inflation has dominated investors’ concerns since the start of the year, and rising prices remain a major worry in many developed markets. Yet traders have now shifted their attention to the risk of recession, as central banks continue to raise rates aggressively, while economic growth is slowing.

If recession is not sufficient reason for concern, markets face further potential risks: corporate earnings estimates may continue to be downgraded as productivity wrestles with ongoing supply chain problems, rising costs and falling consumption.

An alternative course

This uncertain outlook complicates traditional investment strategies. As the first half of 2022 made clear, a conventional 60/40 allocation between stocks and bonds did not deliver the kind of returns investors have come to expect – and offers little protection when both equities and fixed income are equally susceptible to extreme volatility.  At BNP Paribas Wealth Management, we remain neutral overall on equities and credit as an asset class as we await a further potential reduction in uncertainty.

However, globally, an allocation to alternative asset classes is becoming increasingly important for investors who want to meet certain return objectives without taking excessive risks. Many investors are underweight this asset class after the historical bull market in bonds and equities.

Asian investors are at the early stage of this journey, but many are now beginning to consider alternative strategies to buttress their portfolios aiming to improve long-term returns. The negative performance of both fixed income and equities in the first half of this year also bolsters the case for private markets.

Private equity (PE) and private real estate investments are especially relevant in times of stress. Because of their longer investment horizons, meaning they are not as liquid as equities and bonds, PE and real estate funds are less susceptible to short-term volatility and able to take advantage of distressed asset prices when times are tough.

PE funds have shown to consistently outperform public markets over time. According to McKinsey, PE funds were again the best performing private asset class in 2021 with a pooled internal rate of return (IRR) of 27% and assets under management reaching an all-time high of $6.3 trillion.[1]

A ship for all seasons

Interest in these products has grown steadily as more clients realise the value and potential performance this asset class may deliver. Innovations such as ‘semi-liquids’ – for example private real estate investment trusts (REITs) – have also brought this asset class to the attention of investors who are otherwise opposed to being locked up for 7-10 years in traditional, illiquid alternative funds.

In the PE sector, leveraged buyout funds have proven to deliver consistent returns in all weathers, making them a popular addition to core portfolios. In today’s uncertain climate, many investors are also looking to add satellite allocations to thematic funds, such as private real estate or infrastructure funds.

These are defensive strategies that offer some protection against inflation and an economic downturn. High-quality commercial properties, for instance, give landlords have the potential to pass on increased costs to their tenants, while essential infrastructure such as energy, telecommunications and transport tends to deliver cash flows that are more predictable, stable and typically indexed to inflation.

For these reasons, real estate and infrastructure assets remained sought-after among institutional investors in the first half of 2022, accounting for 10% of global M&A by value, according to Dealogic data.[2]

Riding out the storm

In Asia, the percentage of investors with an allocation to private markets remains low relative to other regions. This, however, is slowly changing as more investors gain an understanding of the products and the potential returns on offer. The recent performance of conventional equity and fixed income portfolios is also raising demand for other options.

While this volatile year underlines the appeal of private markets, the uncertain economic outlook makes it hard for investors to commit to any investment that requires a long lock-up period. However, it is worth bearing in mind that funds launched in an economic slowdown tend to be the better performing in the longer run, as they are able to acquire assets at a lower price.

Faced with such an uncertain outlook for global markets, investors may be tempted to wait on the sidelines and seek shelter from further market storms. Inflation, however, is sure to eat away at a cash-heavy portfolio, and there is an opportunity cost to being underinvested when markets eventually recover.

There is no way to predict what lies ahead for investment markets – but while uncertainty and volatility persist, assets that provide an additional balance between stability and returns are worth considering. In many ways, they can offer the safe haven investors seek during adverse conditions. Alternative investments offer a practical way to stay invested without being buffeted by volatility in the public markets.