The strategy aims to allocate dynamically to growth assets (equity & CDS) to accumulate wealth, capital preservation assets (G12 sovereigns) to preserve capital and inflation assets (linkers, inflation breakevens and commodities) to provide real returns. These are the sleeves that define our investment universe around which the strategy is built and risk is managed. We dynamically allocate among the securities in each sleeve and across the sleeves as expected tail correlations change and expected tail gain (ETG) to expected tail loss (ETL) improve and to reduce risk as ETGs to ETLs deteriorate. We adjust the risk level of the portfolio to keep it close to our target drawdown risk. If tail correlations are positive (or negative) among the asset classes, then diversification is not as powerful (or is more powerful) as a result, and we therefore reduce (or increase) the overall risk of the portfolio to maintain risk at our target levels.
Our goal is enhancing compound returns by enhancing the skew of the portfolio and maintaining the expected level of risk close to our target. A high ETG to ETL ratio for an asset or asset class indicates that the distribution of possible outcomes is more skewed to the right. Positive skewness enhances compound returns, and hence this would be an asset that we would want to allocate more towards. Keeping the portfolio risk levels close to target risk levels can also enhance compound returns.
During the fourth quarter, the assets that showcased improved skew were equities and commodities, while that of bonds deteriorated. As a result, our exposure to equities increased to over 50% from 43% at the beginning of the quarter, driven primarily by U.S. equity exposure and followed by emerging markets, in particular Mexico.
Our overall exposure to commodities did not change but our composition within the asset class did. Specifically, while our signals indicate upwards pressure to inflation, we do not see hyperinflation in the cards. We see is inflation normalizing, which we believe will lead rates to normalize. This is all part of what we call the return to the "old normal". Consistent with this view, the attractiveness of gold and precious metals fell as they will likely do well in an excessive inflationary environment with low growth, but characterized with normal inflation and promising growth according to our signals. We believe the demand for precious metals will be tepid at best. On the other hand, we saw improved attractiveness to industrial metals and agriculture given the growth and rising (yet controlled) inflation we see. The attractiveness of oil fell, likely indicative that the upside is capped as increased prices will drive increased shale supply. As a result, our exposure to industrials and agriculture increased from 6% to 12%, while our exposure to oil and precious metals fell commensurately, leaving our overall commodity exposure at 17%.
Finally, during the fourth quarter, our signals continued to indicate higher ETLs for global sovereigns, which we interpreted as "the safe has become the unsafe." Also of equal importance, our signals anticipated the relative attractiveness of TIPS vs. nominal bonds, as well as a steepening of the term structure, thus confirming that long-end rates are much more sensitive to inflation than shorter-end rates since inflation seems to be increasingly sticky and resilient. These signals led us to reduce the nominal duration from 2.4 years to -0.2 years at the end of the quarter and increase our exposure to break-even inflation by over two years. That said, we continue to believe global sovereigns have limited upside potential and, in fact, peak prices may be well behind us. Central banks around the world, especially the U.S. Federal Reserve, seem keen on starting the process of rate normalization sooner rather than later. As previously stated, we believe the Fed is now looking upon fiscal policy as the catalyst for faster rates of economic growth.
Overall, the scarcity of attractive investment opportunities in global capital markets continues. That said, we remain vigilant to capture opportunities as warranted by our signals. Read the full commentary