In today’s dynamic environment, strategic thinking and flexibility are essential. This edition of VantagePoint revisits the core principles of best-in-class investment strategies, exploring how investors can allow wealth to compound by remaining disciplined, diversified, and focused on long-term opportunities while adapting to change. We explore the fundamentals of investment policy development, including conducting an enterprise review to understand investment goals and objectives, setting a flexible policy framework, and revising policies as needed. Additionally, we highlight best practices in portfolio construction and examine how investors can adapt their strategies to navigate today’s challenges and seize emerging opportunities.

Good Investment Policy Starts with Understanding Objectives and Constraints

Successful investors share a key trait: the discipline to adhere to a long-term strategy through both favorable and challenging times. However, there is no universal strategy that fits all. Each investor’s approach must be tailored to their unique return objectives, risk tolerance, financial constraints, investment expertise, time horizon, and resources.

The foundation of any investment plan begins with an enterprise review—a comprehensive evaluation of financial circumstances, risk attitudes, and governance considerations. This process clarifies objectives, constraints, and potential vulnerabilities, helping to mitigate surprises during crises. For institutions, this might involve assessing how asset pools support operating budgets or reliance on endowments. For families, it could mean prioritizing wealth building for future generations, current consumption, or philanthropic goals.

These priorities must also account for evolving portfolio requirements, particularly under stress. For example, institutions facing reduced government financial support may require more support from endowments, while higher interest rates may prompt pension sponsors to accelerate liability hedging as funding ratios improve.

Key considerations include operating liquidity, balance sheet flexibility, liabilities, debt structure, external liquidity access, cost structure, and income or revenue streams. Qualitative factors, such as stakeholder risk tolerance, are equally critical. Balancing short-term portfolio volatility with long-term purchasing power, addressing illiquidity constraints, and aligning with spending, debt management, and other priorities are essential to effective investment planning.

The Primacy of Policy

After completing the enterprise review, the next step is to develop an investment policy, including the formulation of a strategic asset allocation (SAA). An investment policy serves as a ten-year business plan, providing guiding principles and direction, while remaining flexible to adapt to evolving market conditions, assumptions, and execution. SAAs are not fixed anchors but dynamic frameworks that should be reviewed and refined periodically to account for long-term trends.

Historically, SAAs have regularly adapted to changing conditions as reflected in the median target policy allocations below. The most notable shifts have been large increases in target allocations to private equity and venture capital (PE/VC) that provide significant value-added return potential, funded primarily by reductions in public equities. By increasing these allocations, investors have been able to maintain high return expectations even as falling interest rates lowered return expectations for bonds.

Similarly, actual allocations across endowments and foundations in our database reflect sensible shifts. For example, as bond return expectations fell, investors reduced bond allocations and reallocated hedge fund exposures toward absolute return strategies less correlated with equity risk, while trimming equity long/short strategies.

In addition to adapting to capital market circumstances, changes in investment policy often reflect evolving circumstances, such as tax considerations, significant endowment gifts, or shifts in financial strength. Flexibility in portfolio targets and allocations is critical to improving the likelihood of meeting performance objectives as conditions change.

Investment policies should align with the investor’s philosophy and governance structure. Greater latitude for portfolio implementers (e.g., investment staff, outsourced CIOs, or advisors) and longer evaluation horizons typically require less detailed asset allocation policies, allowing for more flexibility in execution.

We begin building investment policy with a foundational framework, such as a 60% equities/40% bonds or 80%/20% volatility-equivalent profile. From this base, we seek opportunities to enhance returns, while maintaining or lowering risk. Some investors may define SAA simply as a stock/bond policy, while others incorporate more detailed categories based on asset classes, objectives (e.g., growth, diversifiers, liquidity reserve), or a hybrid mix. For example, growth assets may be divided into public and private investments. This level of detail fosters alignment among stakeholders, ensuring a shared understanding of objectives, risk parameters, and strategy. Strong governance and clear expectations help keep portfolios on track and aligned with the investment committee’s intent.

Best Practice Portfolio Construction Features

Successful investment strategies begin with a well-designed policy tailored to investor needs and flexible enough to adapt to changing market conditions. Whether through adjustments to SAA, implementation decisions led by portfolio management, or through external asset managers, the following best practices guide our approach to compounding wealth over time:

• Maintain a long-term horizon to capitalize on illiquid asset classes with more potential for value-added returns.
• Use external best-in-class managers and foster lasting partnerships.
• Diversify to enhance long-term risk/return characteristics beyond a simple stock/bond portfolio.
• Adopt contrarian positions with asymmetric return potential by investing in undervalued assets and dislocated markets.
• Define and manage key risks aligned with constraints and objectives identified in the enterprise review.

Playing the Long Game

Maintaining a long-term investment horizon is one of the most challenging yet essential aspects of successful investing. Understanding the historical behavior of markets helps investors set realistic expectations for portfolios and resist the impulse to sell assets or managers based on short-term underperformance. For example, a diversified portfolio with a nominal expected return of 10% and a standard deviation of 13% would see annual returns ranging from -3% to 23% two-thirds of the time. While short-term volatility is inevitable, the range of expected returns narrows over longer horizons.

A long-term perspective enables investors to access illiquid asset classes—such as
PE/VC—which offer greater value-added return potential compared to liquid, efficient public markets. As demonstrated below, the best-performing investors over the long term have consistently maintained higher allocations to these private investments.

Additionally, a long horizon also allows investors to capitalize on undervalued investments. Doing so requires a strong stomach; sharp market dislocations can be quick to reverse, but absent those, valuation disparities are often slow to revert to fair value. Thus, careful judgment is required to avoid value traps. In general, absent other criteria that may serve as catalysts, a seven- to ten-year horizon is advisable. Momentum is also a powerful force and can be a helpful supplement to identify turning points.

Sourcing Best-in-Class Managers

Even the best managers experienced a difficult period relative to passive benchmarks, especially in the large-cap US equity market, given the concentration of performance in the Magnificent Seven heavyweights in recent years. Greater dispersion of returns across stocks globally should increase the ability of skilled managers to outperform. We believe active management can outperform passive benchmarks, particularly in less efficient markets, if investors: 1) employ a rigorous manager research process, 2) exercise patience, and 3) build well-diversified portfolios to reduce unintended risks. Building outperforming portfolios using active managers is hard work but worth the effort.

Engaging in deep research to identify firms with a repeatable competitive edge and strong organization that can stand the test of time is far more relevant than analyzing short-term performance. As the technology and regulatory environments have leveled the playing field for accessing corporate information, managers must work harder to gain an edge. Technology acumen can provide an advantage, but managers must continually invest to maintain their lead. Experience and judgment also go a long way to set managers apart. From an organizational perspective, we advise partnering with firms that have good governance, thoughtful alignment, a strong culture, and a well-diversified customer base of a high caliber. Securing fee structures that enable investors to retain most of the value-added returns also increases the odds of earning excess returns over the long term.

Patience in active management is key, as even the best managers experience periods of underperformance. Behavioral mistakes, such as firing managers after short-term losses, can erode returns. Staying the course through cycles is essential for long-term success.

Dispersion of long-term returns varies by asset class, with more inefficient asset classes exhibiting greater dispersion across managers. The following exhibit shows the importance of manager selection, especially for private investments where manager return spreads are materially wider than for liquid, more efficient asset classes. ¹

Sticking with Diversification

No one can argue with the fact that putting 100% of risk capital in US equities over the 15 years ended 2024 would have been a brilliant strategy. The MSCI US Index returned 13.9%, outperforming the MSCI All Country World Index by 4.1 percentage points (ppts) per year, in US dollar terms. However, such concentrated positioning is risky and subject to sharp reversals amid any change of fortune. Indeed, year-to-date through April 8, lofty valuations combined with prospects for implementation of the highest effective US tariff rates in more than 100 years have seen US equities underperform global ex US equities by roughly 12 ppts, in US dollar terms.

Diversification is a long-term strategy. While a simple portfolio may outperform periodically, a diversified portfolio is expected to generate higher returns over time at a given level of risk—the proverbial free lunch. To better understand the value-added potential of diversified portfolios, we compare the return profile of a simple portfolio of 70% global equities and 30% US government bonds to a highly diversified portfolio constructed to have roughly the same level of volatility as the 70%/30% portfolio. The highly diversified portfolio is expected to outperform the simple portfolio by 100 basis points (bps) over the long term, but could underperform by as much as 100 bps to 200 bps per year over shorter periods. Based on a conservative estimate using indexes to represent asset class returns, over periods of five years or longer ended in 2024, a representative diversified portfolio has outperformed the simple portfolio despite underperforming over the last three years.

The higher expected return for the diversified portfolio reflects the ability to earn incremental returns from various sources, including private investments and pursuit of more diverse market risks. Even after spending more over time, ² highly diversified portfolios are expected to create more wealth through the benefits of compounding. This effect is particularly pronounced over longer horizons.

Tilting Tactical

Another lever that can be used to build returns is tactical asset allocation. This typically involves shorter-term horizon positions that require in-depth analysis, a disciplined process, and risk controls. To develop an investment thesis and exit strategy, it’s important to carefully analyze the historical relationship between the overweight and underweight positions and the environments in which the positioning tends to outperform. Positioning should be sized thoughtfully, scaled by the degree of risk inherent in the position. Ideal positions have higher upside than downside, which is usually derived by relatively attractive pricing for the overweight position. Market dislocations often provide opportune times for initiating tactical positions, so studying asset class relationships and being prepared to take opportunities when they arise is beneficial.

Measuring and Managing Risks

The fundamental purpose of risk management is to provide a clear path for risk assets to compound and build wealth over time. Understanding the portfolio requirements to meet associated spending and liabilities is critical to successful portfolio management. Effective portfolio construction requires identifying and managing risks—such as illiquidity, equity beta, total portfolio standard deviation, drawdown risk, and pension funding shortfall risk—directly, rather than relying on heuristics. For instance, not all public equity portfolios are equally liquid, with emerging markets small-cap and frontier markets equities among the least liquid and US large caps, among the most liquid. Key risks should be identified during the enterprise review and incorporated into investment policy. Management of these risks should focus on taking the right amount, not just limiting risk. Failure to take enough risk could result in underperformance.

Stress testing portfolios to evaluate their resilience under a range of challenging scenarios is a critical component of policy setting and ongoing risk management. The ability to navigate bear markets depends on several factors, including portfolio liquidity, diversification, liquidity needs during periods of stress, and access to external liquidity sources. Such assessments should be repeated regularly over time as conditions change. For example, investors have increased their equity exposure and portfolio illiquidity over the last decade. Understanding how these changes relate to any changes in liquidity requirements especially during times of stress is a core component of portfolio management.

For instance, as demonstrated below using a stylized portfolio reflecting index returns, a $500 million long-term investment pool entering a 2008-like bear market would have meaningfully less portfolio liquidity available to meet cash needs if it had a 50% allocation to illiquid assets compared to a 25% allocation, despite outperforming by about 5 ppts during the drawdown. A high allocation to illiquid assets may be desirable, particularly if the institution can construct a high-performing private investment portfolio. Sustaining such a high allocation requires careful attention to liquidity sources and uses.

The example below shows asset allocation changes before any assets are sold to support cash needs. The ratio of liquid assets including stocks and high-quality bonds to annual cash needs would be 3x, compared to 5x for the less illiquid portfolio. The relatively high allocation to high-quality bonds would have provided a lifeline for the more illiquid portfolio, covering nearly two years of cash needs. Higher cash needs would constrain the ability to maintain a high allocation to illiquid assets, while lower cash needs facilitate such positioning. As a general guideline, bear markets tend not to last longer than three years without recovery, so 3x coverage of cash uses with cash sources (inside and outside the portfolio) following a bear market decline is a reasonable target. Under conditions of limited liquidity, the ability to capitalize on market dislocations would largely depend on existing managers, a factor that should be carefully considered during portfolio construction.

Risk management also extends to implementation. Using external managers to add value requires understanding how individual managers interact and align with benchmarks. Unintended risks—such as geographic, currency, economic sectors, and factor exposures (e.g., value, momentum)—can undermine returns if not carefully managed.

Adapting to Change

Portfolios have historically evolved in response to long-term trends, such as US equity and dollar outperformance since 2010, falling interest rates since 1982, and declining geopolitical risk since the 1990s. These shifts have led to increased allocations to large-cap US equities, greater US dollar exposure, reduced fixed income, and fewer hedge funds. As we move through 2025, diversification is showing signs of renewed value, and investors must assess how their portfolios would fare in the event of a reversal of these trends. We review changing economic and market conditions on an ongoing basis, regularly sharing our views on investment implications. All of these long-term trends have potential to shift the investment landscape in unforeseen ways as they evolve and interact with each other. Indeed, the evolution of global trade conditions will influence fiscal and monetary policy, the ability of countries to finance their debt, and the cost and access to materials and technology to fuel AI developments. We focus here on key implications of the end of ZIRP, challenges and opportunities in private investments, and the role of AI. Other increasingly significant factors that can influence markets and investment outcomes include shifting global trade dynamics, geopolitical risks, and climate change. Investors should remain diversified and vigilant, and incorporate these considerations into their strategic planning.

The end of ZIRP has significant portfolio implications. Higher rates suggest improved fixed income returns, but investors must carefully evaluate credit risk. Weaker credits that borrowed short term with an expectation that rates would remain low indefinitely may find their balance sheets stressed. Indeed, the market sell-off has started to pressure credit spreads in some segments of the market. We would seek to take advantage of such opportunities once spreads reach more distressed levels, including through credit opportunity funds or distressed managers that have requisite experience through investing over prior distressed cycles. Strategies like asset backed lending and insurance-linked securities can help diversify away from corporate credit risk and offer attractive spreads.

We regard high-quality sovereign bonds, particularly US Treasury bonds, as the primary part of a deflation hedge or liquidity reserve allocation. However, we acknowledge that such bonds could come under pressure due to rising interest expenses and fiscal imbalances absent successful efforts to improve debt dynamics. Treasuries served their role well this year until this week, providing much needed ballast to portfolios. However, this week saw significant Treasury volatility for technical reasons, amid an unwinding of leveraged positions. The US dollar has been reasonably stable after initially softening this year. However, US dollar weakness may resume for several reasons including concerns over US growth prospects and the tarnishing of the US exceptionalism consensus that has poured capital into US capital markets over recent years. With prospects for more fiscal and monetary stimulus in the EU and China and heightened policy uncertainty in the US, diversified global equity allocations are more compelling. US Treasury bonds remain a core defensive asset, yet diversifying with other defensive assets like inflation-linked bonds and trend-following strategies can provide similar returns with stronger downside protection.

Higher rates also enhance the appeal of hedge funds. In the early 2010s, endowments and foundations allocated nearly 25% of portfolios to hedge funds, a figure which has since dropped to 16%–17%. Equity long/short hedge funds (ELS) saw the largest decline, but we anticipate a brighter future for these strategies. Higher rates improve returns on collateral, short rebates, and equity dispersion, creating opportunities for skilled stock selection. Disruptive trends—such as shifting global trade relationships, advancements in AI, and the energy transition—are likely to sustain this dispersion, benefiting active managers with strong shorting capabilities. While the HFR Equity Hedge Index still underperformed long-only global equities in higher rate periods, equity dispersion provides the opportunity for strong manager selection to close the gap. Indeed, what matters is achieving equity-like returns over the investment cycle, not matching equity returns in any one period.

And of course, higher rates pose challenges for leveraged strategies like buyouts, requiring general partners to focus on improving operating margins and revenue growth to offset higher capital costs. While valuations remain elevated, they have moderated from ZIRP-era highs.

More broadly, we expect private investment performance to improve as the impact from funds’ rapid deployment of capital into overvalued assets in 2021–22 recedes. Current conditions will likely see some improvement in relative performance as market corrections have a lagged and muted impact on private investments relative to public markets. Yet, the widely expected improvement in IPO and merger & acquisition prospects may need to wait as the current environment is not conducive to improvement in the exit environment. These conditions are ripe for bringing attractive buying opportunities in the secondary market.

Disciplined investors should not be deterred by the recent underperformance of PE/VC relative to public markets. Private markets continue to offer compelling opportunities, particularly for managers with strong operational expertise. The advantages of operating outside the public market’s quarterly reporting pressures remain intact. However, investors should be mindful of the growing retail interest in private investments, which could lead to crowding at the larger end of the market. Further, investors must be exceptionally discriminating if considering investing in supersized funds, given the significant revenue to these managers through management fees relative to carry and the greater difficulty in delivering top quartile returns with very high assets under management. In private investments, effective implementation is critical to generating value-added returns that justify the illiquid, long-term exposures and the significant resources required for success.

Technological advances in AI have potential to create significant value across all sectors over time. To date, much of AI’s impact has been concentrated in public companies—namely chipmakers (e.g., Nvidia, Taiwan Semiconductor) and hyperscalers (e.g., Amazon, Alphabet)—and venture capital. Over time, opportunities will expand as AI integrates into broader industries. Private equity strategies can leverage AI to unlock value in low-margin businesses, while public companies across sectors—such as security, data analytics, and software—will increasingly adopt AI tools. Hype around generative AI’s capabilities has lifted valuations in the near term, but longer term, the transformative potential of AI underscores the importance of staying attuned to technological developments.

Conclusion

In the face of uncertainty, the investment planning process should embrace humility and avoid the pitfalls of overconfidence. For high total return–oriented investors, our approach combines the stability of a predominant allocation to equities and equity-like investments with a diversified and flexible approach. While the aggregate allocation to these growth-oriented assets should remain relatively constant, their composition should be diversified and adaptable, evolving in response to attractively valued opportunities and focusing on identifying best-in-class managers. Without adequate diversification, portfolios risk becoming overly concentrated and excessively volatile. Similarly, diversifying assets should encompass a range of strategies, with allocations shifting toward the most compelling opportunities as they arise.

For taxable investors, the cost of adjusting asset allocations can be significant, shaped by factors such as trust structures, tax status, and the availability of losses to offset realized gains. As a result, any shifts in asset allocation should be carefully evaluated, ensuring that the expected benefits outweigh the associated costs.

In a world defined by shifting economic regimes, technological disruption, and evolving market dynamics, investors must embrace a strategic, flexible, and forward-looking approach to portfolio construction. By adhering to core principles—such as maintaining discipline, embracing diversification, and managing risks thoughtfully—investors can navigate uncertainty and capitalize on emerging opportunities. Adapting to change is not just a necessity but a competitive advantage, enabling investors to build resilient portfolios that align with their long-term objectives. As the investment landscape continues to evolve, those who remain vigilant, innovative, and committed to their strategy will be best positioned to succeed.

Celia Dallas, Chief Investment Strategist
Grayson Kirk and Graham Landrith also contributed to this publication.

Footnotes

1. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
2. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.

The post VantagePoint: Strategic Portfolio Construction in a Changing World appeared first on Cambridge Associates.

Markets have reacted sharply since US President Donald Trump announced his reciprocal tariff plan on April 2. Global equities have fallen 16.5% from their February peak, while ten-year US Treasury yields declined as much as 70 basis points (bps) over roughly the same period. Bond yields reflect weaker growth expectations and the market’s anticipation of aggressive Fed easing. Federal funds futures now price in 100 bps of rate cuts by year end, double the Fed’s March projections. However, the Fed may disappoint markets by moving more cautiously, given the announced tariffs complicate the outlook. Initial estimates suggest tariffs could reduce US real GDP growth by 1 percentage point (ppt)–2 ppts but increase inflation by up to 2 ppts. This stagflation shock challenges the Fed’s ability to act decisively, as it must weigh inflation risks against growth concerns. While the Fed cut rates during the 2018 tariff episode, it is less likely to do so now due to heightened inflation risks. Fed Chair Jerome Powell recently emphasized that the central bank is still not in a hurry to lower rates despite the recent market volatility.

To be clear, this is not a repeat of 2022. At that time, the Fed was aggressively hiking interest rates in response to a spike in inflation caused by both a supply shock and pent-up demand following the pandemic. In contrast, the Fed lowered its policy rate by 100 bps in the past year in response to declining inflation and a normalization in the labor market. The Fed’s current target policy rate range of 4.25%–4.50% remains restrictive, well above its longer-run neutral rate of 3.0%. However, it paused further rate cuts following its December 2024 meeting to assess the impact of previous actions. While tariffs add complexity to this assessment, the Fed maintains an easing bias and the bar for rate hikes remains high.

There is a risk the Fed acts too late if it waits for clear signs of labor market weakness in response to tariffs. Recent data suggest the US labor market was reasonably strong ahead of the tariff announcement. The Fed faces a key challenge: forecasting the impact of tariffs on the labor market as most labor market data are either coincident or lagging indicators. This complicates the Fed’s decision making. The Fed will likely closely monitor timely indicators—such as survey data on hiring intentions or qualitative insights from its regional banks—for early warning signs about the labor market. So far, these indicators suggest softness but not outright distress. Heightened credit, liquidity, or funding market stress could prompt the Fed to intervene sooner, potentially through measures like expanded liquidity lines, quantitative easing, or other unconventional measures. However, the Fed will be hesitant to cut rates decisively absent a material increase in downside growth risks relative to upside inflation risks.

Bonds have been a reliable safe haven during the initial equity sell-off, but stagflation risks and tariff uncertainty have introduced volatility. Despite the potential for near-term fluctuations, bonds remain a critical diversifier. Tariffs may have a temporary US inflationary impact, but they could ultimately prove deflationary depending on their effect on the real economy. If recession risks grow, the Fed has room to cut rates significantly, as it has done in past downturns. Still, if a recession develops, then equities have more downside and Treasury securities should provide further protection. For example, US equity prices have fallen 18.0% from their February 19 peak through yesterday’s close. Comparatively, previous bear markets without a recession average a 23% decline, while those with a recession average a 39% drop. ³ Bonds, meanwhile, have returned just 3% on average during equity bear markets without a recession, compared to 14% during recessions.

In sum, the Fed will likely wait for clear signs that the labor market is deteriorating before cutting rates. At that point, we could already be in a recession. In that eventuality, the Fed has ample room to cut rates, making bonds a reliable diversifier. Investors should maintain bond allocations at policy target weights.

TJ Scavone
Senior Investment Director, Capital Markets Research

Footnotes

1. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
2. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
3. For US bear markets, we include price decline greater than 19%, as opposed to the typical definition of 20%, to increase the number of observations.

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Most Major Central Banks Should Continue Easing in 2025

Celia Dallas, Chief Investment Strategist

Moderating inflation and near-trend economic growth will allow most major central banks to bring policy rates toward neutral in 2025. Market expectations have fluctuated throughout the year and are now more aligned with central banks. Consequently, we expect the upside for sovereign bond performance is likely limited.

The US Federal Reserve initiated its easing cycle with a 50-basis point (bp) cut in September, responding to a labor market slowdown and reduced inflationary pressures. Similarly, the European Central Bank (ECB) and Bank of England (BOE) have cut rates, driven by weak domestic growth and decelerating, yet still elevated, inflation. Japan is an exception, facing continued inflationary pressure exacerbated by a weak currency and slow economic growth. The Bank of Japan (BOJ) has signaled its commitment to gradually increasing policy rates.

Moderating inflation in 2025, even if it remains above target rates, gives central banks the leeway to cut policy rates, increasing the likelihood of a soft landing. While central banks are not fully transparent about their policy plans, their estimates of the neutral rate, or R*, provide insight on their intentions. Indeed, the Fed’s median Federal Open Market Committee (FOMC) members’ long-run policy rate expectation is 2.9%, equivalent to their current R* estimate. The Fed anticipates a gradual approach to reach R*, aiming for 2026, based on their latest released estimates. The ECB and BOE have less distance to ease to reach neutral, while the BOJ needs to move in the opposite direction. Still, markets are pricing in easing of roughly 85 bps in the United States and the United Kingdom and 148 bps in the euro area.

Market expectations have converged toward those of central banks over the last year and now look reasonable based on current growth and inflation conditions. We reckon expectations will remain volatile as policy uncertainty stemming from the US presidential election results have broadened the range of potential economic outcomes.

Bonds Should Outperform Cash in 2025

TJ Scavone, Senior Investment Director, Capital Markets Research

In 2025, bonds will likely outperform cash, driven by supportive economic conditions and attractive valuations. However, the outcome of the US presidential election could counter these tailwinds if Trump fully implements his policy proposals. Consequently, we maintain a neutral stance on high-quality bonds and duration exposure.

Cyclical conditions support high-quality bonds. Inflation has declined and the imbalances in the labor market have closed, while we expect economic growth to remain close to trend across developed markets. This scenario increases the likelihood of continued disinflation. As a result, we anticipate lower policy rates next year as central banks focus more on labor market weaknesses than inflation. As this happens, cash yields will likely fall below bond yields, making cash less attractive. High-quality bonds typically deliver higher returns, both in absolute terms and relative to cash, when inflation and growth slow, central banks ease monetary policy, or the yield curve slopes upward. Most of these conditions are moving into place heading into next year.

However, the US presidential election outcome could somewhat offset these factors. Trump’s proposed policies on taxes, tariffs, and immigration likely pose an upside risk to bond yields if fully implemented, all else being equal. This concern contributed to ten-year US Treasury yields rising roughly 40 bps in recent months. As a result, some of this risk is now reflected in the price and yields are beginning to look somewhat elevated compared to economic fundamentals. US ten-year Treasury securities currently yield 4.2%, which is above our estimated fair value yield of 4.1%. Furthermore, while these policies could temporarily inflate consumer prices, their impact on growth is more uncertain and could detract from GDP growth next year.

Given this uncertainty, we recommend a neutral allocation to high-quality bonds. While we do not see enough evidence to support a tactical overweight at this time, we advise against reducing exposure in favor of shorter-duration assets or cash, given cyclical tailwinds and attractive valuations.

Inflation-Linked Bonds and Nominal Bonds Should Deliver Similar Returns in 2025

TJ Scavone, Senior Investment Director, Capital Markets Research

Inflation-linked bonds (linkers) are set to generate solid returns in 2025 due to higher real yields and favorable global economic conditions. While we expect disinflation to continue, we also anticipate breakeven inflation rates will remain rangebound. ⁴ Therefore, we believe linker and nominal bond returns will be similar next year.

The real yield on the Bloomberg World Government Inflation-Linked Bond Index reached 1.5% as of November 30, which is back within its pre-Global Financial Crisis (GFC) range. With real yields well above zero, linkers once again provide a positive real return and serve as a viable inflation hedge. In fact, linkers are among the few major asset classes we expect to deliver positive real returns in another inflation shock, according to our scenario-based return projections.

In 2025, linkers should benefit from similar cyclical tailwinds as nominals. However, linkers tend to outperform nominals when inflation expectations rise. The next year looks mixed in this regard. Inflation has fallen substantially from its post-pandemic peak, and we expect it to continue moving toward central banks’ targets. This will likely cap market-based inflation expectations. Currently, ten-year breakeven inflation rates in the United States are 2.3%, which is firmly within their post-pandemic range. On the flipside, we see limited room for breakeven inflation rates to fall below their post-pandemic lows absent a recession. As such, we expect breakeven inflation rates to remain rangebound in 2025.

A supply shock would likely benefit linkers, but these are hard to predict. For example, the escalation of the conflict in the Middle East has not challenged supply chains or the production of key resources like oil as some expected. Tariffs are another unknown. While they increase consumer prices, their effects are temporary and are unlikely to sustainably lift inflation expectations.

In summary, we believe linkers will generate solid returns in 2025, but we do not see a compelling case to overweight or underweight them versus nominal bonds.

Footnotes

1. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
2. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
3. For US bear markets, we include price decline greater than 19%, as opposed to the typical definition of 20%, to increase the number of observations.
4. The spread between nominal and real yields.

The post 2025 Outlook: Interest Rates appeared first on Cambridge Associates.

Real interest rates have increased substantially in recent years, making real yields offered by global inflation-linked bonds, particularly US TIPS, more attractive than they have been in a long time. The Bloomberg US TIPS Index had a real yield of 2.0% as of July 17, which has slightly decreased from its recent peak but is still over 300 basis points above its all-time low set in 2021. This is a substantial move. Consequently, real yields in the United States have approached the 65th percentile of their historical distribution, which ranks best among global peers. Additionally, ten-year real yields in the United States surpass the yield implied by the trend growth rate of the economy (a proxy of their fair value) by nearly 1 standard deviation—another indication that real yields are elevated.

With the rise in real interest rates, investors can once again consider inflation-linked bonds a viable inflation hedge. These bonds pay a real return plus inflation over their life, making them appealing for buy-and-hold investors with significant exposure to real liabilities. Their value diminished when real yields neared zero or turned negative and inflation remained muted, as was the case for much of the previous decade. Today, however, both real yields and inflation have risen, making the math for inflation-linked bond returns more favorable. At a minimum, inflation-linked bonds should return around 2% at maturity, assuming inflation is 0%, but they should return between 4% and 5% if the markets’ expectations about inflation averaging slightly above 2% prove correct, and possibly 5% to 6% if inflation exceeds expectations.

In addition to compensating investors for inflation over time, inflation-linked bonds should perform well in another inflation shock. According to our scenario-based return projections, commodities and inflation-linked bonds are the only two major asset classes we expect to have positive annual real returns in a scenario modeled on an inflationary environment like the 1970s, with 7% average inflation over the next three years. Unlike most other inflation-sensitive assets, inflation-linked bonds typically offer a real yield and lower volatility. They are also resilient in various economic scenarios, including typical deflationary shocks associated with most recessions. Because of these unique characteristics, inflation-linked bonds may provide more broad-based portfolio diversification benefits and superior long-run returns than other inflation-sensitive assets, such as commodities, in both nominal and risk-adjusted terms.

While there is a lot to like about inflation-linked bonds, they do have shortcomings. They tend to underperform other high-quality bonds, such as nominal Treasury bonds, over short periods when inflation falls and over time when realized inflation is below expected inflation. They also exhibit less liquidity and have faced pressure during previous periods of stress, such as in March 2020. Additionally, inflation-linked bonds are sensitive to rising real interest rates, which can partially offset their inflation benefit over short periods. This sensitivity led to their unsatisfying performance during the recent bout of inflation. However, higher starting real yields make this less of a headwind today. Based on our modeling, US TIPS would return 2.6% per annum over the next three years in a stylized scenario based on a repeat of the 2021–23 inflation shock—a marked improvement from the actual -1.3% per annum return they achieved from 2021 to 2023. Performance would be even better if the rise in real yields is less pronounced, given that they are not as depressed as they were previously. We would still expect inflation-linked bonds to underperform other inflation-sensitive assets in this scenario, as they tend to have a lower beta to inflation. Still, even though investors may not get the most bang for their buck in an inflation shock with inflation-linked bonds, they can feel confident that these bonds once again provided a reliable hedge against inflation and have outperformed other inflation-sensitive assets, usually with less volatility, in the long run.

Given their attractive real yields and unique characteristics, investors should consider inflation-linked bonds a valuable component for portfolio diversification in today’s uncertain economic environment. For buy-and-hold investors with significant exposure to real liabilities, these bonds provide a reliable hedge against inflation and have historically outperformed other inflation-sensitive assets with less volatility over the long term. In an era of heightened economic uncertainty, where inflation poses a potential risk, including inflation-linked bonds can enhance portfolio resilience and provide peace of mind.

TJ Scavone, Senior Investment Director, Capital Markets Research

Footnotes

1. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
2. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
3. For US bear markets, we include price decline greater than 19%, as opposed to the typical definition of 20%, to increase the number of observations.
4. The spread between nominal and real yields.

The post Are Inflation-Linked Bonds Attractive? appeared first on Cambridge Associates.

The reduction in the ECB’s policy rates was well signalled by governing council members and was enabled by a persistent disinflationary environment over the past year. While preliminary inflation data for May came in hotter than anticipated, headline inflation has nonetheless moderated from a peak of 10.6% in 2022, to 2.6%. However, the recent uptick in sequential monthly inflation prints has served to curtail the total quantity of easing expected from the ECB this cycle. At the beginning of the year, approximately eight cuts were expected, with the trough priced in for late 2025. By contrast, between five and six cuts are now cumulatively priced in through the end of 2026.

The Federal Reserve’s peers have typically lagged its moves in monetary policy, particularly in cutting cycles, for fear of material currency depreciation, which could result in imported inflation. That worry is ameliorated for the ECB this time around by a couple of factors. One is that the market has already priced in a certain amount of policy divergence between the United States and Eurozone, thereby mitigating the market impact when this eventuates. The other is that the growth impulse is lower in the Eurozone—the first quarter improvement notwithstanding—and would more clearly benefit from a reduction in interest rates.

While the level of inflation has, until now, hampered the ECB’s ability to cut rates to support economic activity in the bloc, policymarkers’ confidence has grown that inflation will return to their 2% target. Business indicators, such as PMI output prices and the euro area survey of selling price expectations, have been reliable leading indicators of inflation and point to further declines ahead. Similarly, though wage growth remains high, it has reliably lagged the Harmonised Index of Consumer Prices inflation by a year, suggesting wage pressures should continue to moderate and the risk of a wage-price spiral is low. Nonetheless, the last mile of normalisation will likely be bumpy. The fact that the ECB raised their near-term growth and inflation projections indicates they will want to see further evidence that disinflation is continuing before delivering additional rate cuts.

Monetary easing should serve to foster the European economic recovery that began in first quarter 2024. This broadening out of economic growth beyond the United States should act as an earnings tailwind for DM small-cap equities, which have a greater cyclical tilt than the broad market. The prospect of a turn in the interest rate cycle should also aid the many small-cap firms that have struggled under the weight of higher rates, due to greater leverage and shorter debt maturities. This convergence of fundamentals can serve as the catalyst for narrowing the substantial valuation gap that currently exists between small caps and their larger peers. All told, this environment should be conducive to small caps repeating their historic tendency to deliver excess returns during economic recoveries and expansions.

Thomas O’Mahony
Senior Investment Director, Capital Markets Research

Footnotes

1. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
2. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
3. For US bear markets, we include price decline greater than 19%, as opposed to the typical definition of 20%, to increase the number of observations.
4. The spread between nominal and real yields.

The post European Central Bank Cuts Interest Rates by 0.25% appeared first on Cambridge Associates.

Why Private Credit?

The private credit asset class benefits from several characteristics that we believe are attractive to investors’ portfolios. The asset class has a contractual maturity date, often benefits from collateral, and is senior to the equity in the capital structure. These attributes provide compelling downside protection and a shorter duration relative to private equity (PE) and venture capital (VC).

Private credit has historically outperformed public leveraged finance asset classes such as BSL and high-yield bonds. As a private investment, the asset class exhibits less volatility than the publicly traded markets. While public and private credit marks will be driven by credit quality, public markets also include an element of supply/demand (market technical) that can cause mark-to-market price volatility. Depending on credit quality, private credit spreads tend to be 200 basis points (bps) to 600 bps higher than public markets (Figure 2).

Direct lending loans are floating rate, which have limited interest rate risk and help to protect a portfolio from rising rates. Loans will typically be structured with an interest rate floor, which will ensure a minimum level of income. Most strategies will distribute interest income quarterly, and, with an average life of three to four years, principal is returned at a significantly faster rate than private equity strategies. Additionally, with a contractual maturity date, private credit funds have shorter lives than other private investment strategies.

Relative to public markets, private credit strategies offer investors stronger alignment of interest. In the public markets, whether high-yield or BSL, underwriting banks have an originate-and-distribute model. In this model, the underwriting bank will view the borrower as their client, not the investor or holder of the loan. The motivation for the bank as intermediary is to obtain the best deal for the borrower that will clear the market. In private credit markets, the general partner (GP) is often the originator of the loan and the manager of the risk. The GP views the limited partner (LP) as its client, and its objective is to get the best deal possible for the fund.

Private credit strategies, particularly direct lending, benefit from downside protection through a number of contractual provisions. Financial maintenance covenants provide an early warning to deteriorating borrower performance, allowing for lender intervention and the ability to work with the company to influence an improvement plan. Lending on a first-lien senior-secured basis means that the direct lending loan is secured by assets of the company. In the event of a restructuring, private credit’s position in the capital structure means that it will receive a recovery before the equity. If the equity is worth anything greater than zero, then the direct lending loan will receive all its money back plus a return.

Private credit includes a diverse array of strategies allowing investors to build a portfolio of complimentary strategies. The section below reviews the sub-asset classes in more detail, but we believe that the diverse strategies available in private credit allow an investor to construct a portfolio that will be less correlated to equity markets and can produce stable, attractive returns.

Sub-asset Class Review

Figure 3 depicts how private credit strategies offer a range of return targets and fund lives.

Senior Debt

Senior debt, or direct lending, refers to funds that lend money to performing companies on a first lien senior secured basis. The loans will be used for a variety of purposes, including financing leveraged buyouts and acquisitions, funding growth, or repaying existing debt. The company may be owned by a private equity firm (sponsor-backed) or a public or privately owned company (non-sponsor-backed). Managers will tend to focus on company size, with lower middle market defined as companies with $10 million to $50 million of EBITDA; core middle market as companies with $35 million to $100 million of EBITDA; and upper middle market as companies with greater than $100 million in EBITDA. Sponsor-backed core middle market is considered the most competitive area of the market. Upper middle market competes with the BSL market, and, as such, tends to feature weaker terms and less favorable pricing.

The loans will generally be floating rate, based on the secured overnight financing rate (SOFR) plus a credit spread, minimizing interest rate risk, and issued below par to create original issue discount (OID). The loans will be secured by the assets of the company. The fact that the loans are generally secured by all the assets of the company is important as it impacts the recovery value. Historically, first-lien debt has an ultimate recovery value of 70%, while unsecured bonds have a recovery rate of 47%, according to Moody’s.

Senior debt funds may use fund level leverage to increase the capital available for investment in order to increase the returns. Leverage will generally be non-recourse to the LPs and will not be mark to market. The leverage provider could be a bank, another fund, or a structured finance vehicle such as a collateralized loan obligation. The debt used for this purpose will be secured by the loans owned by the portfolio and not by the obligation of the LP to fund a capital call. This is different from a subscription line, which is secured by the fund’s right to call capital from the LPs. Subscription lines do not increase the amount of capital available to invest but instead change the timing of the cash flows, which could increase the internal rate of return. Generally, private credit funds use subscription lines only to facilitate capital calls and will pay the lines down to zero periodically.

Subordinated Capital

Subordinated debt is a loan or security that ranks lower than other loans with regard to claims on assets or earnings. Subordinated debt is a riskier form of debt as it is not repaid until after unsubordinated (senior) debt holders have been repaid in full. Often called mezzanine debt because it ranks between the senior debt and the equity of a company, the debt will frequently include some form of equity, either a co-investment in the common equity alongside the private equity owner or warrants.

The subordinated capital category also includes capital appreciation strategies. These funds will invest, typically in performing companies, anywhere in the capital structure from senior debt to preferred equity. The debt investment will often include some form of equity upside, such as warrants, preferred securities, or in the common equity. As the demand for mezzanine debt has waned in recent years, many mezzanine debt managers have migrated to this strategy. In both traditional mezzanine and capital appreciation strategies, the returns are driven by both the debt security and the equity ownership. Typically, a subordinated capital fund will include between 10% to 20% equity exposure.

Credit Opportunities and Distressed

Credit opportunities refers to a broad range of strategies that are typically opportunistic in nature, meaning they are either investing in companies in stressed or distressed situations, or addressing an unmet capital need in a creative way. Credit opportunities funds may have a broad spectrum of credit and debt-related investments across geographies. Investments can be made in performing, stressed, or distressed companies, and can be directly originated and structured in the primary market or reflect purchases of securities in the secondary market. While the return of a credit opportunities fund will be focused on income, there will often be an element of equity return or capital gain, particularly in more distressed situations.

Credit opportunities managers may pivot to a greater focus on distressed when market default rates rise to elevated levels. Some managers are exclusively focused on distressed situations. Distressed investors target companies or assets where the company is at a high risk of entering bankruptcy or restructuring. While it is not the intent of the fund to own the company, the manager is prepared to take equity through a restructuring and own that equity for a period of time. This strategy differs from distressed for control strategies, where the explicit purpose of purchasing the debt security is to take ownership of the company through a restructuring of the debt. We view distressed for control as more of a private equity–type strategy, as the manager seeks to own and manage companies as its primary activity.

Specialty Finance

Specialty finance managers pursue a very broad array of niche strategies, requiring highly specialized expertise. A key feature of specialty finance strategies is that they provide diversification away from single name corporate risk—either by lending or investing in pools of assets—or investing in assets that are not correlated to equity markets. A common strategy is to lend against a pool of financial assets, such as consumer or small business loans. The fund is essentially funding the non-bank originator of the loans who may remain as the servicer of the loans. The loans are placed into a special purpose vehicle, which insulates the investment from distress at the originator as the loans can be moved to another servicer. The loan will be structured by looking at historical default and loss rates and requiring the originator to retain the first loss piece, or cushion, to the pool. This is similar to the process used to create asset-backed securities. Another common strategy is for the fund to own a portfolio of equipment, such as rail cars or aircraft, and lease the equipment to create a cash flow stream.

Other strategies include investing in royalties. In life sciences, managers may invest directly in the royalty, helping the company or other entity that owns the royalty to monetize its asset by allowing the fund to collect the royalty payment for a period of time. Similarly, in music royalties, the artist can monetize its catalogue by selling the royalty payments. Increasingly, life sciences managers have moved to a lending strategy where the patent is taken as collateral. This will shorten the duration of the investment. Additional strategies include life settlements, insurance, trade finance, litigation finance, and non-performing loans.

Specialty finance can have a wide range of return targets and duration depending on the strategy. Consumer lending tends to be very short, while royalties—particularly music royalties—can be very long dated. Returns can range from the high single digits to the high teens.

Implementation

With the variety of private credit strategies available, we believe it is possible to create a well-diversified portfolio that can generate income and provide some upside. We like to construct portfolios with a mix of senior debt, credit opportunities, and specialty finance strategies (Figure 4). Senior debt strategies generate cash flow and provide a ballast to the portfolio, offering downside protection and income. A credit opportunities strategy should generate returns higher than direct lending during benign markets, and, importantly, will benefit from market stress and dislocations. The funds can offset any stress that may be seen in the senior debt strategies during periods of elevated defaults. An allocation to specialty finance will provide diversification away from single name corporate risk.

When constructing a portfolio, an investor’s primary objective will influence allocation to the different sub-strategies. For example, an income-oriented investor may focus on direct lending strategies, picking a diversified group of managers to gain exposure to sponsor and non-sponsor and across the borrower size categories. This portfolio may also consider an allocation to income focused specialty finance strategies to provide some diversification. The portfolio should provide a stable income stream, 100 bps to 200 bps higher than the public leveraged finance markets, with lower volatility and risk profile.

Investors more focused on returns will gravitate to higher returning strategies in credit opportunities and distressed. Strategies may focus across different asset classes, such as corporate, real estate, and structured products. A portfolio constructed this way could be attractive to a tax-paying investor, as it can focus on strategies that offer a greater degree of capital gain relative to income.

Investors seeking a diversified allocation to private credit may invest across the different sub-asset classes, such as senior debt, credit opportunities, and specialty finance. We believe that a portfolio constructed this way can deliver an attractive income stream, coupled with some higher returning credit opportunities strategies that can also benefit from a dislocation. The addition of specialty finance will serve to diversify away from corporate risk. Investors can weight the components depending on their preference for income relative to higher returning strategies.

Investors allocate to private credit from various parts of their portfolios. Some investors will have a specific allocation to private credit as part of their total portfolio. Investors that allocate from their illiquid buckets will often focus on higher returning strategies as they are comparing the funds to their private equity and venture allocations. In a zero-rate environment, many investors looked to direct lending to improve returns in their fixed income allocations. Finally, many investors have looked to their diversifiers bucket to carve out a piece to allocate to private credit, recognizing that the lock-up nature of the funds is illiquid relative to the rest of that allocation, but that the private credit portfolio can generate some income and an attractive return.

Conclusion

The private credit market has developed and evolved significantly since the GFC. The asset class includes a broad array of strategies to satisfy investors’ return objectives. Strategies can be cash flow generating and offer shorter duration than other private investment strategies. Downside protection creates an attractive risk mitigant relative to private equity and venture strategies. Investors can construct portfolios to provide income, benefit from market dislocations, and provide some diversification away from single name corporate risk.

Frank Fama, Co-Head of Global Credit Investment Group

Walker Haymond, Brittney McManus, and Ilona Vdovina also contributed to this publication.

Index Disclosures

Bloomberg Aggregate Bond Index
The Bloomberg Aggregate Bond Index is a broad-based fixed income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.

Bloomberg US Corporate High Yield Index
The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high-yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on the indexes’ EM country definition, are excluded. The US Corporate High Yield Index is a component of the US Universal and Global High Yield Indexes. The index was created in 1998, with history backfilled to July 1, 1983.

Bloomberg US Treasury Index
The Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting. The US Treasury Index is a component of the US Aggregate, US Universal, Global Aggregate, and Global Treasury Indexes. The index includes securities with remaining maturity of at least one year. The US Treasury Index was created in March 1994, and has history back to January 1, 1973.

Morningstar LSTA US Leveraged Loan 100 Index
The Morningstar LSTA US Leveraged Loan 100 Index is designed to measure the performance of the 100 largest facilities in the US leveraged loan market. Index constituents are market-value weighted, subject to a single loan facility weight cap of 2%.

Footnotes

1. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
2. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
3. For US bear markets, we include price decline greater than 19%, as opposed to the typical definition of 20%, to increase the number of observations.
4. The spread between nominal and real yields.

The post Private Credit Strategies: An Introduction appeared first on Cambridge Associates.

The rallies in both bitcoin and gold since last fall have certainly been noteworthy. Bitcoin fervor has returned, owing to two factors. First, the SEC approved spot bitcoin ETFs in January, making it easier for investors to access and triggering significant investment inflows. Second, the anticipation of bitcoin’s fourth “halving” event, which will decrease the rate of new bitcoins entering circulation, sparked speculation that the fair value of bitcoin exceeds its recent price. The digital currency reached $73,000 by mid-March, surpassing its November 2021 high. It climbed 190% trough-to-peak since its September low, representing the ninth time that bitcoin has seen a price increase of more than 100% without a significant price reversal during the run-up. ⁵

Gold’s surge has been driven by geopolitical tensions, an uptick in central bank purchases of gold, and the decline in the US ten-year Treasury yield. On the latter, the US ten-year Treasury yield has declined by roughly 70 basis points to 4.3% since mid-October, which has decreased the opportunity cost of holding gold. As a result, gold gained 10% over that same period and is currently near an all-time high of just under $2,200/troy ounce. This has been a sharp rally by gold’s standards.

But focusing on prior rallies is only half of the story. After each of the prior eight episodes when bitcoin gained more than 100%, it experienced a median drawdown of 30%, which often happened in less than a month. It is also worth noting that bitcoin plummeted 77% in just over one year after reaching its last peak of around $68,000 in 2021. Gold’s drawdowns have been fewer and smaller in magnitude. Still, since 1990, it has seen nine drawdowns with a median of -22%, and these drawdowns occurred after gold had rallied by around 40%.

Still, we view bitcoin and gold as different investments. We see bitcoin as highly speculative, and we believe it will behave like other risk assets in a market downturn. In contrast, gold has a more proven track record as a reliable haven instrument, meaning it may perform well in a risk-off scenario.

All this is to say that these rallies in bitcoin and gold may be overextended when viewed with a historical lens. At the very least, investors choosing to add either asset should size positions modestly, understanding that rapid price swings are likely to persist. Recent price action in bitcoin furthers this point; in the week since it reached its all-time high, it saw a 15% pullback in its price. For those investors thinking of adding gold as a potential source of portfolio protection, we favor long US Treasury securities, which also offer that benefit and include the added bonus of a healthy yield.

Sean Duffin, Senior Investment Director, Capital Markets Research

Footnotes

1. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
2. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
3. For US bear markets, we include price decline greater than 19%, as opposed to the typical definition of 20%, to increase the number of observations.
4. The spread between nominal and real yields.
5. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.

The post Should Investors Chase the Bitcoin and Gold Rallies? appeared first on Cambridge Associates.

Global inflation fell sharply in 2023. One broad measure of G7 economies indicates inflation fell to 3.1% year-over-year in November 2023, down from 7.3% one year earlier. So far, the decline in inflation has been primarily driven by lower commodity and goods prices, which have come down due to a normalization of supply chain disruptions. Services inflation has been slow to moderate and, given recent shipping disruptions in the Red Sea, some have wondered whether inflation may again accelerate. We doubt it.

Shelter prices were one of the biggest contributors to sticky services inflation in 2023, particularly in the United States. US shelter prices rose 6.2% over the last year in December, accounting for more than two-thirds of the 3.9% increase in US CPI excluding food and energy (i.e., core CPI). Elevated shelter prices have led to a divergence between two key measures of inflation, core CPI and the core Personal Consumption Expenditures (PCE) Price Index, the Federal Reserve’s preferred metric. The latter has a much lower weight to shelter and rose just 2.9% year-over-year in December, which is a full percentage point less than core CPI! In fact, core PCE is below the Fed’s 2% target over the previous six months. Further, real-time indicators of rental prices, such as the New Tenant Rent Index, point to a steep decline this year in shelter inflation, which is itself a notoriously lagging indicator.

The trend in core services ex shelter prices, or “super-core” inflation, also appears to be headed down. Prices of these services are closely monitored by central bankers as a signal of cyclical inflation because of their tight relationship with labor market conditions. Resilient growth and tight labor markets supported wages and the prices of some core consumer services in 2023. This likely isn’t sustainable. Tight monetary policy and fading consumer tailwinds (e.g., a decline in excess savings) both point to a more challenging growth environment going forward. Analysts project real GDP will expand just 1.5% in the United States, 0.5% in the Eurozone, and 0.3% in the United Kingdom this year. And while labor markets are tight, they are softening. For example, a decline in US job openings and quit rates has already put downward pressure on wages. The US Employment Cost Index rose by a relatively weak 0.9% in fourth quarter 2023. The anticipated downshift in economic growth should accelerate this process and, in turn, pull down wages and super-core inflation.

As previously mentioned, the initial fall in inflation has mostly been driven by the normalization of supply chains. This process is now mostly behind us. The latest reading of the Fed’s Global Supply Chain Pressure Index is back in line with its historical average after spiking during the pandemic. However, lower commodity prices, stable input costs, and an expected downshift in global growth all suggest goods categories will likely continue to be a source of disinflation. Recent shipping disruptions in the Red Sea have led to an increase in global freight costs and a marginal deterioration in supplier delivery times. However, the disruption to date pales in comparison to the pandemic and the broader price impact appears modest.

Major central banks in recent months have opened the door to the possibility of cutting interest rates in response to the accelerated decline in inflation. Central bankers face two-way risks as they attempt to appropriately calibrate the timing and magnitude of cuts. Wait too long, overtighten, and cause a recession, or ease too much, too soon, and cause inflation to reaccelerate. In our view, the broad trend in inflation remains down and this calls for most global central banks to at least modestly lower policy rates this year. The combination of lower inflation and policy rates should pull Treasury bond yields down across the curve and cause yield curves to steepen. As such, we continue to recommend a tactical overweight to US long Treasuries.

TJ Scavone, Senior Investment Director, Capital Markets Research

Footnotes

1. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
2. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
3. For US bear markets, we include price decline greater than 19%, as opposed to the typical definition of 20%, to increase the number of observations.
4. The spread between nominal and real yields.
5. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.

The post Will There be a Second Wave of Inflation? appeared first on Cambridge Associates.