Inflation and the correlation conundrum: Why it’s time to look at liquid alternatives in a new light

We have entered a vastly more challenging macro environment. Central banks are now primarily focused on tightening monetary policy to curb inflation, which is at levels not seen since the early 1980s. Economic growth is a second-order consideration.

One of the key consequences is the breakdown in the bond/equity correlation. This will pose challenges for investors relying on traditional balanced portfolios, suggesting a greater reliance on other sources of portfolio diversification.

In this article, we assess what the current macro environment means for asset allocation and the potential role of liquid alternative strategies, including our own AIMS Target Return strategy, offering benefits traditional portfolios are unable to access.

Rising inflation and the shifting macroeconomic landscape

Beginning with the global financial crisis and ramped up during COVID-19, easy monetary policy coincided with the longest equity bull run in history, aided by the tailwind of low inflation. Bonds played their traditional role of safe haven in dampening volatility, but also provided strong returns.

More recently, we have seen the reversal in the bond/equity relationship. Many are now speculating as to whether the era of the 60/40 portfolio has ended.¹ With the MSCI World Index of global equities falling 20 per cent in the first six months of the year – the worst performance on record – and aggregate bonds down close to 15 per cent in USD-hedged terms (as measured by the Bloomberg Global Aggregate index), strategies that rely heavily on combining these assets have seen little diversification benefit.

Correlations have gone from being generally negative over the last 15 years to becoming neutral and occasionally positive in recent months as large parts of the equity market reacted badly to rising interest rates. The correlation of asset returns is an important consideration for constructing diversified portfolios, hedging strategies and managing risk.

Figure 1 shows the relationship between inflation and equities/bonds correlation from the 1970s to the first decade of the 2000s. For simplicity, we focus on the US, specifically correlation between the S&P 500 and ten-year Treasuries. However, this analysis can also be applied to other regions.

We see a clear relationship between correlation and inflation, with inflation typically far higher pre-2000 compared to post-2000. While most of the pre-2000 period saw positive correlation, post-2000 is characterised by negative correlation, which balanced portfolios have become accustomed to.

Rising inflation has a direct negative impact on nominal bonds and potentially equities as both equity and bond prices can be thought of as being determined by a series of discounted future cashflows. Rising inflation against a backdrop of weak economic growth is a particular pain point for investors.

To illustrate this, Figure 2 shows a simple macro framework using growth and inflation as the key drivers of bonds and equities, where we have the following scenarios:

1. Quadrant 1 represents a balanced reflationary environment with strong growth, rising but controlled inflation and steady, rising bond yields. This is generally negative for bonds but positive for equity markets.
2. Quadrant 2 characterises an “everything rally” environment based on strong growth driven by loose monetary policy and low inflation. This is supportive for bonds and equities.
3. Quadrant 3 portrays a growth shock situation. In a flight to quality environment, bonds typically outperform equities.
4. Quadrant 4 represents a period of rising inflation and higher interest rate expectations, which hurts equities and bonds.

Figure 2: Simple macro growth/inflation framework

Source:  Aviva Investors, Macrobond. Data as of August 31, 2022.

Scenarios 1, 2, and 3 present periods we can identify in the recent past, which balanced portfolios have managed to navigate. Scenario 4 reflects the new macro environment - a less familiar path that will prove more difficult.

As such, building portfolios that are risk diversified, flexible and able to preserve capital through varying market conditions is more crucial than ever. Increasingly, the answer may not lie in the traditional split of equity and bonds, but a combination of different, resilient strategies – some of which may be less conventional in nature.

Liquid alternatives in a new light?

The long bull run in equities and bonds caused most non-directional alternative strategies to lag in performance, leading investors to question their viability. However, the changing market landscape necessitates a more considered appraisal of the role of alternatives.

Surging inflation and the subsequent rise in interest rate expectations and volatility comes with greater dispersion and opportunities to generate alpha. Accessing return drivers outside of traditional long equity and credit markets can enhance returns as well as provide diversification.

To demonstrate this, we examine the impact of including AIMS in a diversified portfolio of developed and emerging market equities and bonds over multiple time horizons (Figures 3 and 4). Over a three-year period, its inclusion provides an uplift of about 65 basis points, which provides an appreciable benefit when considering the impact on compounded returns. Over a shorter two-year horizon, as the theme of rising inflation post-COVID and the bond/equity correlation breakdown starts to emerge, the uplift from including AIMS TR is particularly noticeable, between two to four per cent annualised.

Figure 3: AIMS Target Return efficient frontier analysis: Three-year daily data (per cent)

Past performance is not a reliable guide to future performance. The value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested.

Note: *Poly. = polynomial best-fit line. Global equities is represented by the Bloomberg ticker MSCI ACWI Index, Emerging market equities by MXEF Index, US Treasuries by GOVT US Equity, Global Agg bonds by LEGATRUU Index.

Source: Aviva Investors, Bloomberg. Data as of August 31, 2022.

Figure 4: AIMS Target Return efficient frontier analysis: Two-year daily data (per cent)

Past performance is not a reliable guide to future performance. The value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested.

Note: *Poly. = polynomial best-fit line. Global equities is represented by the Bloomberg ticker MSCI ACWI Index, Emerging market equities by MXEF Index, US Treasuries by GOVT US Equity, Global Agg bonds by LEGATRUU Index.

Source: Aviva Investors, Bloomberg. Data as of August 31, 2022.

Figure 5 breaks down returns within AIMS TR by risk drivers over its three-year investment horizon. The portfolio generated meaningful gains across duration strategies, consisting of long positions at the beginning of the period, as well as short-duration positions to capitalise on the recent rising rate environment. In addition, the ability to access non-traditional markets such as volatility, commodities and inflation contributed positively to performance.

Global macro multi-strategy solutions such as AIMS TR can provide greater risk factor diversification and access to a broader investment universe with more flexibility. Additionally, their broader macroeconomic view drives both idiosyncratic idea generation and portfolio construction. This differs from a traditional strategic asset allocation approach, meaning investors benefit from an additional level of diversification. 

Building resilience into a multi-strategy portfolio

Investors can’t always be right. To maximise the probability of achieving excess returns through good times and bad requires a well-diversified and risk-controlled mix of strategies, with robust management of tail risk. This requires expertise in risk factor analysis and quantitative techniques, alongside diligent oversight.

Embedding diversification and resilience is a key area of focus in our AIMS investment process. The strategy is composed of 20-30 diversified strategies, with a two- to three-year investment horizon that can take both long and short views across the following risk drivers:

The strategies are categorised into the following three buckets:

• Market Return strategies are dynamic allocations to market directional positions, which are expected to perform well in rising markets (e.g., long equities and credit)
• Opportunistic Return strategies seek to capitalise on macro and idiosyncratic investment themes that are less dependent on the direction of the broader market (e.g., relative-value market-neutral trades)
• Risk-reducing strategies help stabilise performance through capital preservation positions (e.g., long duration, tail hedging, systematic strategies)

Market Returns: Resilient market directional positions

In the new macro environment, simple directional bets carry more risk. Solutions that can move away from static allocations using derivative overlays alongside dynamic scaling and market tilts should be able to mitigate some of those risks and improve their overall return profile. 

This is a feature of Market Returns section of the portfolio via risk-mitigating systematic options structures and market regime models. We believe this helps us better express macro-driven ideas in sector- or region-specific equity positions during rangebound markets or periods of volatility.

While the strategies may be systematic, there is considerable discretionary oversight as to when they are deployed. Models can isolate a return source from historical data, but qualitative judgement is required to decide whether the source will continue to be rewarded.

Figure 6 shows a static equity allocation across our Market Returns directional positions would have resulted in a loss of 2.2 per cent in May 2021 to July this year. By contrast, the use of convex options added 74 basis points to portfolio performance, while the market regime model added 42 basis points.

Putting this alongside the 158 basis points uplift from macro-driven regional and sector-specific views, the Market Returns section of the portfolio generated a gain of 55 basis points. For reference, the MSCI ACWI lost 400 basis points over the same period.

We believe the use of systematic models, overlaid with discretionary oversight to inform asset allocation and position management, enables investment views to be expressed more accurately and in a timely manner. This can lead to alpha generation with improved risk-return characteristics. While useful in all market cycles, such tools are particularly useful in an environment where natural risk-reducers are limited.

Opportunistic Returns: Widening the investment opportunity set

The Opportunistic Returns section focuses on strategies exhibiting a higher degree of market mispricing and/or a lower degree of correlation. AIMS TR goes beyond conventional asset classes to use nonconventional markets and techniques, including investing in volatility as a credit proxy and relative-value trades.

Since mid-2018, considerable enhancements have been made to the AIMS investment process that involved investment into 3P’s – people, platform and process. One of the key focus areas was on improving the performance of, and expanding the investment toolkit within, the Opportunistic Returns section.

The steps taken have delivered positive outcomes across different market conditions. As illustrated in Figure 7, since the investment process enhancements were fully embedded at the beginning of 2019, Opportunistic Return strategies in aggregate generated positive returns in 11 out of 14 consecutive quarters, which includes the COVID-induced market turmoil of Q1 2020, as well as the market volatility witnessed in 2022.

Risk-reducing Returns: Diversifying away from traditional safe-havens

Sourcing robust strategies that can preserve capital is critical. Long duration, as many balanced portfolio investors are painfully aware, has not provided much protection recently. In the short to medium term, interest rates are more likely to rise than fall, reducing the likely effectiveness of government bonds.

Shorting duration has proved an effective hedge against rising rates, a position held within the Opportunistic section. This is not a stable long-term hedge, however. When yields reach reasonable valuations, we expect long bonds to revert to their traditional safe haven status. In the meantime, our focus within the Risk-reducing section of the portfolio has been to complement the convex options implementation by embedding tail-risk protection through discretionary options hedging strategies.

Systematic strategies are another area we have explored to improve the Risk-reducing section. Like the systematic value equities position held within the Opportunistic section, the strong balance sheet strategy is constructed as an equity relative-value structure but harnesses the quality factor through long positions in companies with strong balance sheets. This has worked especially well during periods of credit stress and rising defaults.

Currencies have historically offered portfolio protection. However, these require more active position management as varying rate hiking cycles amongst central banks have broken traditional safe haven patterns. A prime example is the Bank of Japan, where its yield curve control policy to suppress interest rates combined with low inflation has seen the currency massively underperform the US dollar.

Portfolio-level resilience

Despite directional Market Return positions being a significant contributor to returns, the strategy’s portfolio construction has helped generate performance with relatively low beta to global equity markets, as demonstrated by the total line in Figure 8. An additional benefit of options implementation is it reduces equity market sensitivity. Therefore, even though the Market Returns beta has been higher recently, the actual sensitivity to equity markets is lower due to the convexity embedded in the portfolio.

Another measure to evaluate resilience is the ability to preserve capital through periods of market stress. Figure 9 illustrates the performance of AIMS TR during the ten worst rolling three-month periods of equity declines since the strategy’s inception; AIMS TR fared relatively well during the most difficult periods for equities.

Resilience requires alternative sources of returns

Investors face an extreme inflationary environment, the like of which we have not seen for forty years. This is creating a material shift in the bond/equity correlation.

The diversification implications cannot be overstated. Resilient portfolios now require an ability to source other return drivers and implementation techniques capable of performing during periods of rising rates and equity market volatility. 

AIMS TR, through its unconstrained approach, harnesses expertise from a broad array of investment professionals to access a wide range of ideas and expand potential sources of return and diversification.

We strongly believe its ability to access a much wider range of targeted implementation methods, as well as draw informed views on dynamic position management, is particularly valuable in this market environment. This combination offers resilience to an investor’s overall portfolio in a liquid and cost-effective manner.