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Inflation, Elections and Everything Else Impacting Your 2024 Portfolio

Inflation, Elections and Everything Else Impacting Your 2024 Portfolio

  • As central banks around the world consider easing their monetary policies, inflation remains a significant risk factor in portfolio allocation.
  • U.S. private growth is far outpacing Europe, but American politics arguably create more uncertainty than the EU’s moves in the next few months. The 2024 U.S. election will have reverberating global macro impacts.
  • While predictable interest rate changes favor a 60/40 portfolio allocation, diversification into structured products and trend following may provide even more upside in periods of high volatility.

Inflation is like politics — we’re hearing a lot about it in 2024, and most people wish the topic would go away.

But as we look ahead to pivotal elections in the second half of the year against the backdrop of a tense, populist-driven geopolitical climate — where are markets moving, and what allocation strategies are best suited to manage volatility?

To answer these questions, co-host Cem Karsan and I met with Christian Mueller-Glissmann, Head of Asset Allocation Research and Managing Director at Goldman Sachs. It’s been six months since I last spoke with Christian about his investment framework, and we’ve since seen an optimistic equities market in the U.S. and hints of a reversal in the Federal Reserve’s monetary stance. Meanwhile, European markets are also preparing for a rate-cutting cycle, and the manufacturing and energy sectors are in focus as world leaders lean into protectionist policies.

On the latest Global Macro episode of Top Traders Unplugged, Christian discusses the complexities of capital allocation in an uncertain geopolitical climate, and we assess the benefits and drawbacks of using a traditional 60/40 allocation benchmark. From wide-angle views on European and U.S. markets to specific insights on investment strategies, here’s what to watch for in the coming months.

The state of market sentiment

In 2022, we lived under a cloud of recession fears, and then in 2023 sentiment swung the other way with bullish expectations of the so-called Goldilocks scenario where growth would continue and inflation would come down.

“Since the beginning of [2024],” Christian says, “the sentiment has shifted from Goldilocks to a bit more pricing reflation.” Referring to an increase in money supply and a stimulation of the economy, reflation policies typically follow periods of economic contraction.

In our present context, central banks may look at signals that inflation is declining, lending has decreased and key markets are losing liquidity, and decide that it’s time to slash interest rates. The risk, of course, is moving too quickly to loosen monetary policy before inflation comes down to target levels, a concern reiterated at the most recent meeting of the U.S. Federal Reserve.

“I think the problem right now is this ‘reflation flirtation’ turning into desperation because you obviously have inflation potentially being more sticky than you'd like,” Christian notes.

While Christian doesn’t see markets in “desperation” mode quite yet, he highlights the concern around high equities and low volatility. If markets are elevated in expectation of central bank policy changes, but inflation stays high, a renewed uncertainty will bring more volatility to the stock market.

“The market is potentially getting very sensitive to growth in the next few weeks,” Christian says. “We’re coming back to this idea that inflation is actually uncertain, more volatile and potentially becoming more of a risk factor in the portfolio on a more sustained basis.”

Drivers of inflation

Structurally, what’s propping up inflation despite the decrease in money supply? Christian looks at a series of global macro factors, many of which will be prime topics of debate in key elections later this year.

“There’s decarbonization, deglobalization and demographics on the negative side [of inflation], and then more fiscal dominance and fiscal policy expansion on the demand side,” he says.

To the first point, investing in clean energy and onshoring manufacturing puts pressure on key commodities and elevates prices. Deglobalization efforts also disrupt current supply chains and create economic inefficiencies, and an aging population can also impact employment markets and consumer prices.

On the other hand, a record-high global debt and a loosening of monetary policies are contributing factors to inflation in international markets. As elections for the European Parliament take place in June and the U.S. presidential election occurs in November, how are world leaders responding to these inflationary pressures, and what’s the potential impact on investment allocation?

The U.S. vs. Europe

While the U.S. and Europe have many parallels in their political discourse around foreign policy and economic expansion, structural inflation risk takes different shapes on either side of the Atlantic.

“In the last few months, the European inflation picture has continued resetting whereas the U.S. has stabilized because the growth backdrop is better there,” Christian argues. Several considerations support this claim.

Private sector differences

The European private sector as a whole has lagged behind its American counterpart. The U.S. continues to outperform other nations in economic growth.

In the U.S., says Christian, “Households are doing really well. The unemployment rate is low, and the [S&P 500] is up, which means the households in aggregate actually have a very healthy financial backdrop.” Meanwhile, Europe’s heavy exposure to the global manufacturing recession is a lead weight tied to the region’s economic turnaround.

High debt exposure

The European Union and the United States both have substantial debts on their balance sheets. When nations are heavily indebted, they eventually have to get rid of their bonds, and — with few foreign buyers in the market — this is commonly achieved by offloading the debt to banks. Currently, the U.S. debt represents a higher percentage of GDP, which, in theory, creates a greater structural risk in the U.S. Yet European households are more exposed to the bond market, which means inflation could be more of a risk there. 

Japan is a notable example of offloading debt to banks, and, as Christian notes, “A lot of people say that Japan is the template that Europe might follow.” European households generally have a high allocation to bonds and savings accounts — in part because the return on European equities is so poor. This creates a situation where households are exposed to inflation on both sides of the coin. High inflation means savings are less valuable, but as inflation cools, bond yields fall.

Political backdrop

Yet if inflation is a bigger risk in Europe, politics are a bigger risk in the U.S. “Populism has been a thing in Europe for a long time,” Cem observes, “but the pushback is more significant.” Heavy investment into liquefied natural gas is driving energy costs down while the fiscal policy has a high number of checks and balances.

The U.S., on the other hand, sits on substantial uncertainty regarding its foreign policy, trade relations with China, corporate regulation and other issues depending on who wins the White House later this year. No matter what happens, it will probably be more in favor of U.S. equities than bonds, Christian predicts, but the uncertainty will ramp up volatility.

“Europe, to some extent, looks a bit less scary on the fiscal side [compared to the U.S.], partially because of that political backdrop,” Christian concludes.

Assessing the 60/40

With all these factors considered, what’s the impact on portfolio allocation? Christian suggests taking the 60/40 portfolio as a starting point, then considering how the volatility of inflation will shake up markets.

“The best way to characterize this debate is to ask how many growth shocks are you generating relative to how many rate shocks are you generating?” he says. A “shock” in this sense is a surprise, good or bad, that suddenly swings the pendulum in investor activity.

When most of the surprises are coming from the equities market — a “growth shock” — stocks and bonds tend to have a negative correlation, which benefits the 60/40 allocation. As inflation calms down and central bank moves become predictable, it becomes less likely that investors will be surprised by rate changes, which means fewer “rate shocks.”

But Cem pushes back. If we’re potentially looking at long-term structural inflation, he wonders, “Why should 60/40 always be our starting point?”

Christian answers, “Generally, when you have high inflation periods, the optimal portfolio tends to shift towards 100% equity, but you need to own the right equity.” Of course, unless you can predict the future, a smart portfolio is a diversified one. The optimal asset mix may include commodities, real estate and other alternatives to de-risk in periods of global economic uncertainty. An allocation closer to 60/40 is perhaps a safer play when volatility could swing.

Volatility in a holding year

Cem describes the holding pattern in U.S. markets, and effectively the global markets, as investors await the result of the presidential election. “There are all kinds of things that won’t happen or are less likely to happen,” he says, from corporate actions to geopolitical events.

In other words, it’s the calm before the storm.

This creates an opportunity for structured products that offer downside protection against high volatility while still holding growth potential. Christian sees some benefits in capital-guaranteed products, “if you’re in a low-vol regime with high rates.” Macro conditions favor bullish sentiments on equities, and bonds still have a decent coupon before central banks cut rates.

Cem adds that perhaps with so much expectation for volatility and risks to increase, implied volatility could compress, creating a long-term trend that requires more active portfolio management to find the most profitable opportunities. “It might be very bearish for implied volatility in the next decade,” he predicts.

Keys to strategic allocation

Between the tried-and-true 60/40 and a step into trend following and structured products, portfolios could go many different ways as we await central bank policy changes and the upcoming election results. In closing, Christian offers a few allocation principles.

Stay balanced

While higher-for-longer inflation naturally offers more opportunities in equity markets, bonds can provide some stability. “I think the bond market at four-and-a-half-percent yield provides you a buffer for growth shocks,” Christian says. If there is some sort of economic disaster, the surest position is a balanced one.

Look beyond the dollar

If inflation remains high in the U.S. while other places — such as Europe — see inflation come down, the real yield on U.S. equities will start to look less attractive. “The further out you look, the more you worry about the stickiness of inflation and surely you need to diversify that risk,” Christian says. “That’s where commodities come in.” He sees gold in particular as a hedge against economic stagnation.

Remember the cycle

Finally, we can remember that economic fluctuations are cyclical. While there’s quite a bit of geopolitical weight impacting the next few months of 2024, that pressure will abate, and then in a few years, the pattern will repeat. “We’ll have to diversify and manage inflation risk in the portfolio much more [now and going forward] than in the last 20 years,” Christian predicts. While markets can sometimes feel unpredictable, there are always patterns and trends to see that will aid in portfolio allocation.

This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.