When risks collide

Read this article to understand:

• Why supply-side challenges mean inflation could prove sticky
• Why that spells uncertainty for stock-bond correlations
• The case for adding liquid alternatives to a traditional stock-bond portfolio

Bonds and equities are an essential component of most investment strategies. The so-called 60:40 portfolio is a traditional approach that allocates 60 per cent of a fund’s assets to equities and 40 per cent to bonds. It assumes investors recognise the trade-off between risk and return. The aim is to provide long-term growth and income while reducing risk.

The strategy relies on the fact bond and equity returns do not move in tandem with one another. The chart below shows calendar year returns for equities and bonds since 1991. It is immediately apparent that whereas equity returns tend to be quite volatile, bonds have delivered more consistent performance. That has allowed them to play a vital role in smoothing overall portfolio performance. 

Until recently, a secular decline in inflation and interest rates had pushed both bonds and equities steadily higher. Better still, on the few occasions equities did decline, such as during the global financial crisis, investors were invariably able to rely on bonds for some protection. As Figure 1 shows, equities delivered negative returns in nine different years. In six of those years, bonds helped limit these losses.

This relationship between equity and bond returns can be measured mathematically in terms of their correlation. For more than two decades starting in the late 1990s, the long-term return correlation between equities and bonds was broadly negative, as seen in Figure 2. This made this period something of a golden age for the 60:40 portfolio. 

However, that benign picture changed dramatically in 2022 as surging inflation led to the sharpest rise in interest rates in a generation. Both equities and bonds suffered a double-digit decline. And it proved to be an equally disastrous year for so-called balanced funds, as the correlation between the two suddenly shot up.

Some commentators were left to ponder whether the benefits of the 60:40 portfolio had been overstated. After all, investors in balanced funds were left nursing a similar sized loss to those who had invested in equities alone.

Despite the events of 2022, equities and bonds will no doubt remain a mainstay of the vast majority of investment portfolios. But that does not diminish the significance of the recent shift in the stock-bond correlation. One of the most important questions investors are now grappling with: Is this a short-term blip or does it mark the start of a new regime?

As Figure 2 shows, while the equity-bond correlation may have been reliably negative for more than two decades prior to 2022, the reverse was true for the preceding twenty-five years.

A wide range of factors can influence bond and equity prices, including the real level of interest rates, rates of inflation and economic growth, and investors’ risk appetite. That makes predicting returns, and the correlation of those returns, complicated.

For instance, while a period of higher inflation would almost certainly lead to a decline in bond prices, its impact on equities is indeterminate, as companies may on occasion manage to grow real earnings.

Likewise, other things being equal, higher interest rates ought to lead to negative returns on bonds and equities since the price of both reflects the discounted value of their future cash flows. But if this were to coincide with stronger earnings growth, equities could conceivably rise, leading to a negative correlation.

Disentangling each of these impacts is not straightforward, but Figure 2 supports the idea that the stock-bond correlation may be driven to a large extent by particular aspects of the underlying macroeconomic and policy environment.

The first half of this period was characterised by supply-side economic shocks and high and volatile rates of inflation. That caused central banks to hike interest rates steadily including at moments when equities were falling. Hence the positive correlation.

The first two decades of this century by contrast were characterised by stable and low inflation and a steady decline in interest rates. Cuts in interest rates and rises in bond prices often coincided with sharp declines in equity markets such as during the financial crisis, leading to a negative correlation.

At first glance, it might appear from Figure 2 that the spike in inflation and interest rates in 2022 has brought this period of negative correlations to an end. But it is probably too soon to draw such a conclusion. Much will most likely depend on how successful central banks are in taming inflation.

With many of the world’s leading central banks having already begun to cut interest rates in the belief inflation has been largely slayed, the shift into positive territory of the stock-bond correlation could prove short lived.

Then again, it is possible that higher inflation uncertainty, and with it the upward shift in the stock-bond correlation, persists. Commodity shortages as the world attempts to tackle climate change and other supply-side shocks stemming from military, or economic and trade, conflicts, are plausible reasons to believe inflation may prove more volatile and harder for central banks to control.

That would have broad implications for investors who would be left facing increased portfolio risk or having to make allocation changes likely to lower expected returns. This uncertainty explains why, since 2022, a growing number of investors, both institutional and private individuals, have been turning to alternative investments as a potential source of higher yields, lower volatility and returns that are largely uncorrelated with stocks and bonds.

Consider for example how our Aviva Investors Multi-Strategy Target Return (AIMS TR) fund could potentially boost the risk-adjusted performance of a traditional portfolio invested in just stocks and bonds. Figure 3 shows the annual return that investors would have received over the past three years for accepting different levels of risk by investing in a variety of portfolios.

The efficient frontier line represents a range of risk-adjusted returns for portfolios containing different ratios of equities and bonds, ranging from 100 per cent equities to 100 per cent bonds. The 60:40 portfolio delivered an annual return of 5.4 per cent with an annualised standard deviation of returns of 6.8 per cent.

It is immediately apparent that the AIMS TR portfolio could have helped improve risk-adjusted performance. It returned 7.2 per cent a year with significantly less risk than the equity:bond portfolio that delivered the same return.

That means an investor in the traditional 60:40 portfolio could have expanded their ‘efficient frontier’, in other words improved their portfolio’s risk-adjusted performance, by shifting some of their portfolio out of bonds and into AIMS TR. For example, with a ten per cent allocation to AIMS TR, an investor could have received a higher return (6.1 per cent) for less risk (6.7 per cent) than in the case of the 60:40 portfolio.

The same holds true over a five-year timeframe, as can also be seen in Figure 3. In this instance, by allocating ten per cent of their portfolio to AIMS TR, the investor in the 60:40 portfolio could have increased their expected return to 6.7 per cent from 6.2 per cent, without any change in the level of risk.

Because they tend to behave differently to typical equity and bond investments, alternatives arguably have a useful role to play in investor portfolios. Once the domain of institutional and high-net-worth investors, they continue to grow in popularity and are starting to make their way into the portfolios of retail investors.

Investors have no shortage of options, with a myriad of products on offer. For those interested in taking a more nimble, tactical approach to their asset allocation, liquid alternatives may be of particular interest.

They are effectively a liquid hedge fund. Typically structured as a UCITs regulated fund, they offer a higher degree of governance, with transparency around underlying holdings, safeguarding of funds and a more favourable liquidity profile. Adding to their appeal, they are usually priced much more competitively than traditional hedge funds with lower minimum investments.

However, for alternatives to play a useful role, investors need to be reassured they offer genuine diversification with returns that are relatively uncorrelated to traditional asset classes. They should also be capable of preserving capital and delivering resilient returns in a variety of market environments, especially periods of equity market stress.

In the case of the AIMS TR fund, its managers attempt to construct a diversified portfolio, containing a mix of strategies, both ‘long’ and ‘short’, across multiple asset classes, with a variety of risk drivers. Historically it has offered low correlation to global equities with a ‘beta’ of 20 per cent. That helps explain why it has tended to preserve investors’ capital during equity market sell offs.

Understanding return correlations between asset classes is an important component of portfolio construction. In this unpredictable environment, with uncertainty as to the future path of the stock-bond correlation, building portfolios that are diversified, flexible and able to preserve capital through varying market conditions is arguably more crucial than ever.