Inverted pyramid of investments needs shoring up

The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy

Early in my investment management career, I was taught to design long-term investment portfolios as a pyramid. A solid foundation of secular and structural positions, with a much smaller opportunistic and tactical top. In other words, construct a durable structure that could mostly resist unsettling market volatility and navigate economic and geopolitical shakes.

Today, this once-reassuring construction seems to have become gradually inverted: a shrunken secular and structural base now has to support a larger opportunistic and tactical top. It is one that, having proved extremely resilient, is now fuelling a debate between those worried about bubbles and those comfortable that structural reinforcements are just around the corner.

Secular investments play out over time, powered by a maturation of the underlying return drivers that provide for greater investor adoption. It is the sort of process that is now being demonstrated by artificial intelligence-focused chipmaker Nvidia, which has become the market’s darling. The underlying driver there is the potential for large-scale application of an innovation in which the company holds a dominant role at present. The turbo charger of its stock price is the change in its shareholder base from a few highly sophisticated investors to wider buying by the investing public.

Structural investments exploit an investor’s ‘edge’, such as patient capital that can withstand volatility or a structural mispricing due to artificial segmentations in markets. Combined with secular investments, they provide a consistent motor that can generate attractive returns over time.

In a perfect secular and structural investing world, such favourable performance is accompanied by relatively low volatility. At its extreme, it can be the rewarding version of watching paint dry. Because of this, there is scope for investors to comfortably take on more volatile short-term positions, as well as respond faster to opportunistic ones.

Secular investors were helped in the period from the 1980s to 2000s by three major developments. First, agreement that domestic economic wellbeing was best pursued through market-based approaches that emphasised liberalisation, deregulation and fiscal responsibility — the so-called “Washington consensus”. Second, a commitment to rapid globalisation that targeted the ever-closer cross-border integration of trade and investment. Third, a maturation of financial markets including the spread of derivatives, lower entry barriers and the institutionalisation of emerging markets as an asset class.

The first two have now reversed course. The change started after the 2008 global financial crisis and has accelerated significantly since 2017. Market-based approaches emphasising liberalisation, deregulation and fiscal responsibility have given way to the return of industrial policy, heavier government intervention, and sustained levels of fiscal deficits and debt burdens that were once thought highly unlikely. The era of globalisation has given way to fragmentation as the combination of geopolitical tensions (especially between China and the US) and reaction to worsening domestic inequalities have fuelled the weaponisation of trade and eroded global policy co-ordination.

The range of structural investments has also narrowed as dividing lines between investors have dissipated. This is most visible in the host of new vehicles that provide highly liquid access to inherently illiquid investments. An expansion of tactical and opportunistic investments has accompanied this shrinkage of secular and structural ones. Momentum is now well recognised as a factor that allows investors to ride remunerative waves that will break at some point, but not just yet. Such shorter-term positioning is not just about bottom-up opportunities. It can also be driven by top-down factors, as demonstrated in the past six months by the surge of US stock indices to record highs. Continuing US economic exceptionalism — including surprisingly high US growth rates as Germany, Japan and the UK have stagnated — and dovish signals from the Federal Reserve have been important contributors. They have enabled markets to brush aside a host of worries, be they political or geopolitical.

Unlike the pyramids of Giza, this narrow-base/broad-top construction is unstable. It requires reinforcement from better domestic fundamentals, a less problematic international order, and the materialisation of the promise offered by technology, life sciences and sustainable energy. That is certainly a possibility as currently priced in by markets, but it is far from guaranteed.