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Low risk, low inflation, low growth

Risk parity is built for languid times

The post-pandemic world is likely to look different, and as investors, we should reexamine our assumptions of portfolio construction in the context of this new regime. Risk parity, as a diversified, balanced, liquid strategy able to take on leverage, is well-positioned for what we see as the most likely scenario: low rates, low inflation and sluggish growth.

Risk parity strategies are built by diversifying sources of risk rather than asset class. More than ever, we believe these strategies are well-positioned to navigate the potentially turbulent markets ahead and uncertain macroeconomic climate.

The world has changed. Historically reliable drivers of return may fail to deliver if we see sluggish growth driving assets sideways over the coming months or even years. Incorporating many diversified sources of return improves the chances that a portfolio will be able to deliver on its objectives.

Revisiting our long-standing assumptions about portfolio construction

A fundamentally different outlook for markets naturally gives rise to the question: what does this mean for building robust portfolios?

Warning: Slow growth ahead

The exceptional equity returns enjoyed in the decade following the Global Financial Crisis often obfuscate the importance of diversification and the danger in relying exclusively on one source of exposure (namely, equities) to meet investment goals. Equities have been the driving force behind portfolio returns since 2008, but portfolios that concentrate their exposure in this one return source may not fare as well in a post-pandemic world1. The long-term impact to growth assets remains to be seen. Our economic intuition suggests that the risk/return profile is likely to be lower going forward. The impact of higher taxes, government crowding out, de-globalization, and pandemic-related adjustments that will impact productivity are likely to result in a lower, albeit still positive, equity risk premium.

Recognizing the importance of looking beyond equities, we review the historical performance of other assets following periods of stress. Using history as our guide, we can examine the last six post-recessionary periods (illustrated in the chart below) to understand the performance of various asset classes in the 36 months that followed the end of each economic recession. We find that, following all but the most recent recession, equities were not the strongest performing asset. As the U.S. economy slowly got back on its feet, credit, government bonds, and/or commodities outperformed equities.

Annualized returns for the 36-month post-recessionary period

 

Source: BlackRock, Bloomberg, July 2020.

Investors seeking consistent growth might consider balancing exposures across a diverse array of assets that are designed to generate returns in different environments. For example, periods of slow, positive growth tend to be supportive of credit assets, while a rebound in demand would likely benefit a commodity allocation. As emerging markets stabilize, expanding a portfolio’s exposure beyond developed markets can add additional diversifying sources of return to the portfolio. Diversifying your growth portfolio enables us to make better use of sources of return beyond the equity risk premium and fully exploit the benefits of diversification. As history reminds us, a post-recessionary period of sluggish growth may reward investors who diversify portfolios across a balanced set of exposures rather than rely solely on equities as the dominant driver of returns.

Moving forward

A future of sluggish growth and low rates presents challenges for traditional portfolio construction. Given the likely shift in regime as we exit the COVID-19 pandemic, institutions should consider how to add liquid, diversifying allocations which can deliver on return objectives while also serving as a source of safety and resilience during market turbulence. In this environment, we believe the optimal portfolio is one which is balanced across many diversified return drivers and employs a modest amount of leverage to target a level of risk and return consistent with investors’ needs — the blueprint for risk parity.

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Key Takeaways

  • A well-constructed risk parity portfolio can take advantage of multiple lowly correlated drivers of return beyond just developed market equities and government bonds.
  • A sustained low rate, low inflation environment is likely to lead to higher Sharpe ratios and lower absolute returns for bonds.
  • Portfolios which use a modest amount of leverage can scale a balanced portfolio to target a level of risk and return consistent with investors’ needs.
  • If the dominant market risk remains economic growth uncertainty, stocks and bonds will continue to be highly diversifying sources of return.
  • Risk parity strategies can complement traditional institutional portfolios as a diversifying and liquid source of returns.
Ked Hogan, PhD
Managing Director, Head of Research for BlackRock's Factor-Based Strategies Group
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Philip Hodges, PhD
Managing Director, Chief Investment Officer for Blackrock's Factor-Based Strategies Group
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Katelyn Gallagher
Senior Investment Strategist for Factor-Based Strategies Group
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