Asset owners mull correlation and pricing risk

The sharp sell-off in United Kingdom government bonds after the Truss government’s mini budget spooked markets, has underscored the fragility in today’s financial markets. The sell-off also highlighted the importance of credibility in financial institutions, said Craig Mitchell, an economist at the UK’s National Employment Savings Trust, NEST, something that is particularly important given the need to anchor inflation expectations.

Speaking at FIS Maastricht, Mitchell noted that despite rising inflation and interest rates, and a cost-of-living crisis, economies may not experience a long and deep recession because corporate and bank balance sheets are healthier than in past crisis.

He warned that persistent inflation is rooted in the labour market.

“Once you get wages rising, it will stay around,” he said. He also noted that once inflation rises above 3-4 per cent (in the UK it is at a 40-year high of 10.1 per cent) it begins to impact financial markets and asset behaviour.

Mitchell noted how NEST is benefiting from its allocation to real assets in an inflationary environment, for example by tapping rising rental income.

The prospect of stagflation, which is difficult to hedge, is complicating strategy said Harold Clijsen, chief executive of PGB, the Netherlands €34.8 billion ($35.2 billion) industry-wide pension fund. He is currently mulling a balancing act whereby the fund keeps open interest rate risk, but diversifies the portfolio into different strategies in the hunt for return.

PGB’s assets are split 60/40 between a return and matching portfolio respectively. Although rising interest rates and inflation are concerning in the return seeking allocation, they have buoyed the matching portfolio where PGB’s coverage ratio is currently 120 per cent.

The internal team run a dynamic risk hedging strategy whereby when interest-rate risk is low, the fund calculates a lower risk budget and reduces its interest rate hedge; when rates move higher it increases the hedge. At the start of the year around 45 per cent of the liabilities’ interest rate risk was hedged, but this has now risen to around 65 per cent on the prospect of further hikes but where decision making also balances the threat of recession – and lower rates.

Clijsen noted that an end to war in Ukraine will have a key impact on inflation.

“Central banks can do something about demand,” he said, in reference to rate hiking policy. “But we need something else to do something about (energy) supply.”

He said high longer-dated yields threaten recession, yet bringing inflation down also remains key. He added that investors can play between regions to make use of different volatility in a more active stance.

Correlation

Edouard Senechal, senior portfolio manager, SWIB, shared his thoughts on the importance that investors get compensated for market risk. Two key components of market risk comprise volatility and the risk of a correlation between asset classes – particularly bonds and equities which are increasingly moving in tandem because of inflation.

Citing research SWIB conducted last year with other investors, Senechal noted that, “during times of inflation there is a higher correlation (between equities and bonds) and during times of lower inflation there is a lower correlation.”

He added that the pattern was true across most markets and the research drew on historical periods like the inflationary 80s and low inflation during the 90s.

“The correlation has been low and negative for the last 20 years when inflation was low,” he said. “If you look at Japan, declining inflation has led to a decline in the correlation in stocks and bonds.”

Higher inflation leads to more restrictive monetary policy from central banks that is challenging for both bonds and equities with an impact on risk premiums, Senechal continued. He said it is difficult to tell if central banks will get on top of inflation and economies will return to the world we had before, or if inflation remains high creating “a much more difficult environment.”

Panellists noted that central banks ability to control inflation is over-rated. “It’s not clear how much central banks can do,” said Senechal.

If central banks are successful, inflation could go back to 2 per cent by 2025.  Enduringly high inflation will be bad for both equities and bonds as well as asset classes that use leverage like private equity. “There are not many asset classes that can do well in terms of high inflation,” said Senechal.

Expensive equities

Panellists noted challenges in pricing. For example, equities remain expensive, suggesting the market hasn’t yet priced in future inflation scenarios. Moreover, the volatility of short term returns makes it difficult to see if a relationship between asset classes is structural.

Panellists reflected on the importance of robust investment strategies in the current environment. Investors have to weigh whether they want to maximize returns and are willing to take on risk – or minimize the returns they want to achieve.

“Macro uncertainties are much larger than they used to be,” concluded Senechal.