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Diversifying portfolios post-Covid

Covid-markets

Central bank reserve managers should ensure diversification remains “at the heart” of discussions around portfolio construction.

In the latest episode of CB-on-Air’s Partners in Focus series, Johanna Lasker, head of official institutions for BNP Paribas Asset Management, discusses how central banks are approaching the current low-yield environment.

“The risks of inflationary pressures becoming more sustained would argue for more asset diversification into asset classes or sectors that have potential inflation hedging attributes,” she says.

Different asset classes and different sectors will have different sensitivity to inflation. Returns from commodities, for example, demonstrate a strong positive relationship with inflation in the short term.

However, investors will need to balance this with the high volatility associated with commodity prices, which makes their long-term risk-adjusted returns less attractive.

Equities are one area central banks are now considering more seriously when it comes to diversification.

Both the Swiss and Japanese central banks have had equities within their portfolios for quite some time. Since introducing equities to its portfolio in 2005, the Swiss National Bank has reportedly managed an average annual Swiss franc-denominated return of 4.5%, compared to 0.9% on bonds over the same period.

Arguably, the equity purchases by the Bank of Japan are even bolder. The BoJ started what it called “temporary” share purchases in 2010. Since then, the central bank’s equity exchange-traded fund portfolio now amounts to $372 billion (£294 billion), and the central bank is the largest investor in domestic equities. The BoJ’s purchases are ongoing.

“[For equities], while higher discount rates resulting from higher inflation can hurt short-term performance, for sectors that do have pricing power, higher inflation can bring higher earnings growth,” Lasker says.

Another asset to consider, Lasker goes on to add, is US Treasury-inflation protected securities (Tips). These offer investors explicit protection against inflation shocks and protection against deflation, with a deflation floor embedded in some of the inflation linked-securities.

“Tips have delivered strong risk-adjusted returns over the longer term versus equities and commodities,” Lasker says.

“Investors really should consider switching some of their nominal government bond holdings into inflation-linked securities and this is a conversation that has been taking place with many of our central bank clients.”

Index

00:00 Introduction

00:50 Diversification at the heart

02:40 Outlook for equities and corporate bonds

10:46 The problem with ESG screens

14:40: Impact of inflation and higher US bond yields

16:22 The benefit of US Tips

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