PruFund Strategic Asset Allocation Update: Investing at the end of the cycle

Source: Thomson Reuters

At our last annual review we had material concerns that as economies emerged from the pandemic, short-term supply chain disruptions were likely to increase pricing pressures, particularly in more extreme scenarios.

In light of this analysis, we began tilting the portfolio toward assets that offer some degree of protection from inflation along with an additional risk and return premium. We increased exposure to real assets and shifted the fixed income allocation away from developed markets toward emerging market debt and private credit where we were able to obtain further risk premium and less interest rate sensitivity.

In addition, compared to the drawn-out economic cycles that we have become accustomed to over the past 20 or 30 years, recent cycles are much condensed. We are now in the latter stages of the current economic cycle with central banks accelerating their paths of interest rate hikes amid the decades high levels of inflation. Given the strong performance of equities during 2021 and the uncertainty that the war clearly generated, we therefore thought it prudent to make a small reduction in the portfolio’s equity exposure in March. This positioning has benefitted the portfolio’s performance year to date and as we look ahead, we think it will continue to do so.

One region where we have sought to build exposure is India. As a leader in outsourced technology India is, in our view, well placed to benefit from the continuing globalisation of services. We are also increasing the exposure to emerging markets more generally and this includes adding to our allocation to African equities. Elsewhere we have added to the fund’s holdings in Japanese equities, where the reforms of recent years are starting to bear fruit.

Incremental increases are being made to the portfolios real asset allocation, particularly within infrastructure where sustainability and ESG considerations will remain paramount.

The inflation backdrop is especially challenging for fixed income and we therefore continue to transition the allocation away from developed market yields, which offer little compensation and toward emerging market debt. Within equities we are also adding emerging market exposure as well as increasing the allocation to Japan.

Source: M&G Treasury and Investment Office - August 2022

Property, Infrastructure and Alternatives – small increase.

Over the past year, we have built a significant and diversified allocation to real assets that offer medium to long term inflation hedging characteristics. This exposure includes property, infrastructure and private high yield.

Given these additions, real asset exposure is broadly in line with where we want it to be. However, the portfolios will continue to evolve as we add incremental exposure where we think that there is the opportunity to add further value. This opportunity set, is in our view, greatest for PruFund Cautious given its higher allocation to fixed income and therefore inflation exposure.

We are tilting the portfolio’s alternatives exposure away from hedge funds and towards infrastructure, particularly food infrastructure. The problems with food supply chains caused by the Ukraine conflict cannot be ignored by governments. We anticipate a surge in domestic food infrastructure as countries seek to protect themselves from future disruptions.

Within real estate, we are seeking to increase residential exposure outside of Europe. This is an area of the market that is deemed to have stronger links to future inflation and so will in our view provide further inflation protection for the portfolio.

Fixed Income – continue the transition to emerging markets

Given the low level of yields in developed markets and the challenge of inflation we continue to transition the portfolios fixed income exposure away from developed markets and toward emerging markets. This includes issuers in Asia, Africa and Latin America.

Emerging markets have come a long way since the Asian financial crisis in the late 1990’s. Forced to reduce their reliance on external financing, many countries have built up domestic local currency bond markets. In turn, this has given their central banks more credibility and greater capacity to implement policy independent to developed markets. This has been born out in recent years with emerging market central banks in aggregate able to cut interest rates at the start of the pandemic. They were then able to tighten policy as inflationary pressures built in 2021.

Of course the sector still faces some challenges. These include high commodity prices, which are great for exporters such as Malaysia, but not so good for importers of energy such as India and Turkey. Furthermore, food prices also make up a more significant proportion of the baskets of goods used to measure inflation in emerging markets. As a result, food price inflation from the Ukraine conflict will have a more significant impact on emerging markets relative to their developed market counterparts and might mean they need to tighten policy further.  

That all said, the sector offers attractive levels of yield that we believe more than compensate for the increased credit risk of investing. US dollar denominated emerging market debt for example currently offers higher credit spreads than US high yield, but with better underlying credit metrics.

Equities - small increases

The uncertainty surrounding the Russia Ukraine conflict in March led us to reduce some risk within the equity portfolio. Given the subsequent volatility within markets this have proved to be a prescient decision.

In addition to these risk reduction decisions we have made some further small adjustments to the equity allocation. The UK equity market exposure was trimmed following 12 months of strong relative outperformance. We are making small increases the portfolios allocations to emerging markets and Africa, which continue to see positive trade flows. Corporate reforms in Japan as well as valuation considerations favour a small increase in the portfolios Japan allocation. Finally, we are building on the portfolios allocation to India, which we believe will continue to benefit from the globalisation of services.