Corrado Pistarino: There are several themes posing challenges to portfolio resilience. The first is the return of large-scale protectionism, which is what has happened with the US-led tariffs.
This has been threatening to reverse the global trade integration that's been going on for decades partly because of the start and stop attitude from the US, so it's unclear what's happening. Markets have been too quick to dismiss the risk of sustained high tariffs and the fact that there may be sectoral embargoes. There is also potential for capital wars and capital flows with barriers being erected - what has happened in terms of uncertainty will show up in the data. We'll have a measurable and immeasurable economic and market impact.
We are moving into a different type of globalisation; it’s not the anchor that it was over the past 30 years where we saw globalisation as a way of diffusing global conflicts.
The second theme is fiscal sustainability in developed markets. We saw something like that in Europe in 2010-2011 with the Greece crisis, and now this has turned to the US in a staggering development. This fiscal unsustainability is reasserting itself as a key driver of long-term instability.
If you look at the deficit in the US and the projection of this deficit, especially with the new fiscal measures that have been taken by the US Congress and Senate, we are seeing a deficit in the range of 6 and 8% over the next few years as a baseline scenario these numbers had been seen as extreme in the past few years but, now, this is accepted.
"We have seen rates sparking up to levels that we had
not seen since the financial crisis."
But we have seen the market reaction to that movement and there is a combination of high deficits and, an ageing population - more in Europe and Asia than in the US, but with the stops to immigration in the US this could change - and the combination of these movements are leading towards high levels of government engagement and government debt into the economy.
This is a long-term dynamic that markets need to be aware of. We have seen rates sparking up to levels that we had not seen since the financial crisis.
One other thing that our markets are aware of is a concentration of risk in equities. There is a lot of hype around the artificial intelligence (AI) narratives, the hype around the US exceptionalism probably has diminished given the latest events, but there are expectations about earnings, which are fostered by the so-called AI revolution and there are hopes that even modest shifts in sentiment or policy could trigger significant repricing across this type of asset.
This concentration of risk inequities still presents a challenge to any balanced portfolio.
One of the aspects is the movements around capital allocation to the US. The fact that US financial assets have been bitten by foreign investors for at least 20 years now and with the idea that the US is developing at a faster pace, productivity growth is higher and now we have seen a reversal in this trend.
There is a political aspect to that angle that is also an economic driver. There is a twin deficit, both on the trade side and the balance sheet of the US Government, and a structurally weaker dollar, which should attract investments, but at this juncture, it is discouraging investments because people see the value of their portfolio diminishing and there is a general reduction of foreign support for US assets.
In terms of portfolio risk resilience, investors should be looking at portfolios where even passive diversification is not enough now.
Corrado: The baseline is that the UK is structurally vulnerable to external shocks, and this includes energy shocks. It could be terms of trade; it could be that the UK relies on global capital flows. We are running a trade deficit, so it makes it difficult for the UK to decouple from a broader global narrative around monetary policy, for instance.
Investors should be looking at the Bank of England, but shouldn’t ignore what the US Federal Reserve, the Bank of China are doing, or even the European Central Bank are doing, because the Fed is setting the tone.
When we think about allocation, we should look at the global horizon and landscape. One aspect is, as I said, in terms of interest rate trends, we saw at the beginning of May that the Bank of England cut rates, and the Federal Reserve did not.
Even if, arguably, the epicentre of the storm is the US, and people may be concerned about the impact of tariffs on the price level and the consumption and investments in the US, the fact that the Bank of England has taken a different stance may reflect that they have a different understanding of which stage in their respective cycles they are in.
"The Bank of England will have to cut more considering the fact
that the projection for growth is not brilliant in the UK."
But also, they may consider a diverging interpretation of what the easy cycle should be. In 2021, the Bank of England was the first bank to increase rates. There were some synchronisation people at the banks. Now we see a divergence in the way [central banks] interpret their economy and the constraints that they have.
If you look at debt, the real rate in the UK economy is much lower going forward than the US’s real rate and the Bank of England will have to cut more considering the fact that the projection for growth is not brilliant in the UK.
Corrado: When we talk about political risk, it's important to differentiate between tactical responses and long-term positioning, which is mostly strategic.
Over the past 20 to 30 years, because of a certain geopolitical stability, we thought of geopolitical risk as a tail risk. Now, we have become accustomed to the fact that geopolitical events require allocation shifts immediately. They seem to pile up. They’re not a tail risk; they’re a fact of life that you need to contend with continuously.
On the tactical side, you have events that trigger short-term dislocations and thus create opportunities for investors. If an investor’s been clever they may have thought about the escalation of trade tensions between the US and China and could tactically position their equity portfolio or credit portfolio against - or towards - exposed sectors, or play with the currency, or with the rates.
Similarly, for anything energy-related, etc., there are short-term allocation to commodities rotations between assets that are inflation sensitive.
If an investor thinks that this will continue and create an inflation shock going forward, this is the tactical side. But it's also a strategic play, which shouldn't be ignored.
Events like China and the US decoupling, the fragmentation of capital flows, and the weakening of the traditional alliances in the west are not short-term catalysts. Yes, over the short term, they may create some opportunities for portfolio repositioning, but political events start tactically but then become strategic. I would consider this strategic side as a long-term risk and challenge to my portfolio.
It's easier to deal with short-term events because they lead to some tactical repositioning, but it’s more difficult to think strategically and about what the world is going to look like in 10 or 15 years.
Corrado: The Fed may hold rates a bit longer. However, there is a risk that we see some bad data starting from late Q2 or, the beginning of Q3 because of all the erratic messages that have come about.
There is still a case for investing in real rates because high inflation is still lingering. We have seen the Bank of England cutting through inflation but it’s still high in the UK and we still have wage pressures.
"Wage pressure could be key. In the UK there is a policy that has been
announced to cut migration and that reduces the pool of labour."
It's the slowing of the economy that may take care of the inflation and it may dissipate over time but it’s still a challenge given the demographics and other factors.
The wage pressure could be key. In the UK there is a policy that has been announced to cut migration and that reduces the pool of labour. But at the same time, we have policies such as building new homes - which requires builders - and it's not clear where these builders will come from. As an investor, you need to see what an equilibrium point could be.
Corrado: Balancing regulatory constraints with the need for flexibility is a central part of managing a portfolio under Solvency II — especially in a market environment where volatility is no longer episodic, but structural. Solvency II rightly emphasises prudence, risk transparency, and capital sufficiency — but that doesn’t mean flexibility is off the table. It simply means it must be deliberately designed, not reactively improvised.
"Yes, there is a capital diversified by asset class, but the
crux of the matter is the correlation matrix."
I can see a situation where an insurance company that operates within a matching adjustment environment is pushed into an asset because if they are investing based on a regulatory framework that will push them towards a certain type of asset.
There is an increase in systemic risk and a lack of diversification across the industry in those portfolios, which is inevitable because of the structure. But I don't think that regulation per se poses a lot of risk. This is because if you think Solvency II capital requirements are broadly in line with economic capital then it’s fine, but if you think that the world is moving towards one that looks different from what we have seen over the past forty years then you should consider what correlation means now because a lot of capital allocation in institutions is based on a correlation matrix. Yes, there is a capital diversified by asset class, but the crux of the matter is the correlation matrix.
So, when it comes to regulation, especially for people who operate with a standard model, be aware that the correlation structure that is embedded in the standard model may not be as powerful and robust as it used to be.
