Investing amid a shifting policy paradigm

Investing throughout the first twenty years of this century was a relative cinch. Structural tailwinds anchored inflation, compressed borrowing costs and kept asset correlations in check, allowing for a relatively unsophisticated approach to investing.

“The tailwinds that made the first twenty years of this century comfortable have reversed; the tools that succeed in the next twenty will be different.”

That world has faded. Even as the US Federal Reserve continues its easing cycle, the low‑inflation, low‑interest‑rate regime investors grew accustomed to appears extinct. The tailwinds that previously assisted financial markets — abundant global labour, frictionless trade, and monetary dominance — are now reversing. In their place are regime-changing forces: a capital‑intensive green transition, deglobalisation, rising populism and diminishing trust, and demographic shifts that will shrink working‑age populations across developed economies while tilting political priorities toward redistribution.

The policy response is changing

Zooming out though, the past few years have hardly felt like a paradigm shift for investors.

The S&P 500 has delivered more than 15% per annum over the past three years — with similar returns over 2019–2021. But beneath the surface market dynamics have changed. Drawdowns are steeper, rebounds sharper, leadership rotates more frequently, and performance is increasingly driven by rapid policy recalibration rather than the earnings cycle.

The pandemic crash saw a 34% decline in the S&P 500, followed by a full recovery in just five months —the fastest in 150 years. Last year, the market recovered in under two months from a 20% drawdown following Liberation Day.

Recoveries once resembled a misshapen U

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Source: S&P Global, Bloomberg, Macrobond, ANZ CIO

These are not isolated events. Central banks and governments have shown a willingness to act aggressively, often using non-traditional policy measures to avert potential GFC-style meltdowns. Ironically, since the GFC, it could be argued that the newest and most consequential leg of the Fed’s mandate has been to clear the system of excess. Yet, despite repeated shocks — the pandemic, hot wars, the 2022 tightening cycle, bank failures, and tariff regimes — leverage has expanded, not contracted.

The bailout of Silicon Valley Bank prevented broader contagion. The Credit Suisse-UBS merger stabilised European banking. The UK gilt crisis was contained through emergency bond buying; and the Bank of Japan looks to have repeatedly intervened in currency markets this decade. Even tariffs, while disruptive, haven’t triggered a global recession.

This may understandably lead investors — perhaps reasonably so — to conclude policy intervention has raised the bar for systemic risk. But when the financial system absorbs shocks without deleveraging, the eventual fallout is likely to be non-linear and asymmetric.

Demographics and fiscal dominance

Globally, governments unleashed colossal fiscal programs during the pandemic and have shown limited appetite for rectitude since. But this fiscal turn is not solely a crisis response; it is colliding with political reprioritisation, driven by demographic change.

Younger cohorts — Millennials, Gen Z and beyond — will increasingly dominate electorates. For the most part, these generations were unable to participate meaningfully in the multi-decade period of asset price inflation, fuelled by low inflation and low rates.

Accordingly, these demographics are likely to press for fiscally demanding policies that tilt power back to workers through wage floors, bargaining rights, and redistributive taxation. We’re already seeing policy drift. Changes to superannuation tax in Australia, mansion taxes in the UK, renewed debate over death taxes and negative gearing, and the spread of protectionist industrial policy globally. Together, these trends suggest we are entering a world where fiscal activism plays a larger role and monetary policy does less of the heavy lifting.

Fiscal dominance is likely to result in higher debt levels, greater market sensitivity to political decisions and perhaps most consequentially — more frequent inflation spikes. Monetary policy, in turn, may be deployed less in response to growth imbalances and rather in response to managing inflation through the cycle. That task becomes increasingly difficult as rising debt levels potentially constrain how long interest rates can remain elevated.

Correlation conundrum

For investors, this environment requires acknowledgment that traditional hedges may not consistently behave.

In periods of low and stable inflation, if growth surprises to the downside, it indicates potential economic weakness, possibly leading to lower expected earnings for companies, therefore weighing on equity prices. However, it also raises expectations of monetary policy easing, which subsequently boosts bond prices due to lower discount rates.

Conversely, during periods of higher inflation, positive inflation surprises generally impact negatively on existing bonds given that principal and coupons are typically priced in nominal terms. Moreover, upside inflation prints also point to rate hikes, typically weighing on expected future earnings and equity prices by extension.

The result is positive equity-bond correlations more often than not. Since early 2021, the 100-day rolling correlation between the S&P 500 and 10-year US Treasury yields has been positive for significant periods, echoing the dynamics of the “Great Inflation” era. Historical correlations that once underpinned diversification are proving less dependable.

Historical correlations are proving less reliable for investors

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These correlation breakdowns extend beyond bonds and equities. The world has moved rapidly from its unipolar moment, through a relatively brief period of bipolarity into an emerging era of multipolarity. Outside the post-WWII period through to the pandemic, multipolarity has been the dominant state of the international system for most of history.  Such an environment has traditionally harboured increased conflict and heightened demand for strategic resources.

Now, investors must consider whether the US has moved from a behind closed doors controller to an outright bully. Increasing US unilateralism, most recently exemplified by the  Venezuela attack suggests the rules-based order on which global markets have long relied may be permanently fractured. This means a reconsideration of long-held assumptions about trust in the system.

Already, nations are pursuing resilience strategies: alternative trade routes, energy security, and industrial capacity. Consider President Trump’s assertion that the US “needs” Greenland — a territory belonging to Denmark, a long-time ally. Greenland’s commodities are already accessible to the US, yet the rhetoric underscores a deeper reality: in a multipolar world, control — not just access — becomes paramount.

The world has relied on American hegemony and the stability it implied. Yet the past year saw episodes where US equities and the US dollar declined together during growth scares, and Treasury yields failed to deliver the usual hedge. Historically, sharp equity selloffs were buffered by falling yields; recently, that buffer has been muted, yields have rebounded quickly, hinting at an exodus from US assets rather than a flight to safety. Meanwhile, gold has risen sharply despite higher real yields as governments look to diversify US reliance.

What does a potential end to exceptionalism mean for investors?

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Adjusting the portfolio approach

These developments are not anomalies; they are signatures of regime change. In the high‑inflation era 1970s and early 1980s, equity‑bond correlations were often positive: inflation shocks hurt bonds and, by tightening financial conditions, hurt equities too. If we are re‑entering a world where correlations frequently flip, the approach to asset allocation must also change. The correlation between USD and equities is a case in point: if the dollar no longer attracts safe‑haven flows during equity stress, currency hedging and global equity positioning need to reflect that structural shift, not assume reversion to the pre‑2020 norm.

The definition of ‘safe’ also changes. Gold may hedge geopolitical and financial regime risk even when real yields are elevated. Cash regains optionality value when it can be deployed into dislocations. Currency hedging should reflect the possibility that USD and equities move together during stress.

Structural return drivers are also changing. Dependency ratios are rising across developed markets, shrinking labour supply and pressuring potential growth. Emerging markets — outside China — retain favourable workforce dynamics, offering a longer runway for consumption-led growth. Strategically, this argues for lower structural allocations to developed-market equities over time, and higher exposure to regions with better demographic tailwinds, complemented by exposure to alternatives and private markets to diversify return premia and dampen public market volatility.

Where does this leave investors? First the comfort of static allocations and mean‑reversion assumptions should be abandoned. In an asymmetric world defined by fiscal dominance, multipolar geopolitics, and demographic inversion, portfolios must be constructed across three horizons — near-term, cyclical and secular — to capture opportunities while protecting against correlation shocks.

This requires a whole of portfolio approach to strategic and tactical asset allocation. Every asset in a portfolio should have a clearly defined role. Not all positions exist to maximise returns; some are held to protect the portfolio when scenarios diverge from expectations. That protection is not a concession — it is an enabler.

This is not to suggest diversification is no longer important, quite the contrary, it becomes more important than ever. But it’s not just about spreading bets; it’s about dynamic allocation to mitigate tail risks.

Specific assets should be considered through the lens of various scenarios: What protects if an equity bubble bursts? What if a commodity slump hits? What if fiscal sustainability is questioned? What if inflation proves stubborn and growth slows i.e. stagflation?

In this sense, strategic asset allocation, often associated most with long run returns, should be considered strategic risk allocation: that is design a portfolio that keeps you invested through adversity by distributing risk intelligently and adding hedges where historical correlations might betray you.

Tactical asset allocation should then be a re‑optimisation process inside this risk budget, not a bet on one outcome. Adjust weights to increase the likelihood of risk‑adjusted returns under the next plausible path, while preserving the integrity of the overall risk profile.

None of this requires a complete abandonment of traditional portfolio construction, but for some will require a rethink of approach — one centred on risk optimising rather than return maximising.

The tailwinds that made the first twenty years of this century comfortable have reversed; the tools that succeed in the next twenty will be different. Build portfolios for the world we’re entering, and for the transition that gets us there.

Lakshman Anantakrishnan is the Chief Investment Officer with ANZ Private

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