Against a backdrop of rising equity markets and falling bond yields, portfolios dominated by equities and bonds have produced exceptional returns over the last eight years. In addition, investors have enjoyed a long period in which equity and bond returns have been negatively correlated, providing a powerful diversification effect. Looking forward, however, investors need to be prepared for an environment of lower returns from equities and bonds, along with the possibility that the diversification effect will disappear as equity and bond returns become positively correlated.
The negative correlation equity and bond markets have exhibited for most of the period since the early 2000s reflects, in part, the risk-on/risk-off behaviour of markets in which economic disappointment has bred a flight to safety (with bond yields falling), while economic improvement has been positive for risk assets. This diversification effect is not a permanent feature of markets, however, and a much longer-term analysis shows that there have been long periods of time in which the correlation between equities and bonds has been positive (indeed, the long-term average is about +0.1).
A potential catalyst for a return to positive correlations could be a shift towards a more inflationary environment, in which tighter monetary policy and rising bond yields lead to equities and bonds falling at the same time. While higher levels of inflation are far from inevitable, the shift in policy discussions towards fiscal stimulus (evident in Canada, Japan, the US, and to a lesser extent the UK and Europe) at a time of synchronised global growth raises the likelihood of inflationary pressures emerging over the medium term.
This raises two important questions:
- What impact would a simultaneous sell-off in equities and bonds have on an investor’s financial position? This might be particularly important for investors making use of leverage.
- What actions can investors take to improve the robustness of their portfolios in an environment that poses significant challenges to both equities and bonds?
Before considering what portfolio changes might be appropriate, investors need to have a clear idea of the economic/market outcomes they are least able to tolerate. For example, investors who are sensitive to mark-to-market volatility, or who are cashflow negative, may be most concerned about large market moves and a dramatic reduction in liquidity over a short period of time. In contrast, long-horizon investors may be most concerned about the erosion of their purchasing power due to an extended period of higher than expected inflation.
The following questions will help investors narrow the range of scenarios that are likely to be of most relevance to them when reviewing investment strategy.
- What time horizon matters most? Will it shorten during a period of market distress?
- What are the key characteristics of the liabilities (for example, real vs. nominal, the shape of the cashflow profile, and any flexibility in adjusting cashflow levels in difficult times)?
- What external support might be available, if required, in an unfavourable market outcome? Under what conditions is that external support most likely to be compromised?
Identifying the scenarios of most concern to an investor and then testing the portfolio’s most likely response to plausible future outcomes is a critical step in risk management.
Building on the discussion above (which will necessarily be investor-specific), we suggest investors consider potential action at three levels:
- Explicit hedges: Adopt defensive exposures designed to provide explicit protection against one or more market outcomes. This category would include government bonds (nominal and inflation-linked), synthetic hedges (such as option strategies and swaps) and tail-risk hedging strategies. Nominal government bonds still have a role to play in defending against weakening economic conditions and deflationary environments (especially for investors sensitive to those outcomes). Inflation-linked bonds (where they are issued) will offer some exposure to rising inflation alongside their interest rate exposure, and synthetic hedges can be tailored to meet individual needs.
- Defensive tilts: Recognising the return drag typically associated with explicit hedges, investors should also consider tilts (whether in the growth or defensive portfolio) that might improve robustness in scenarios to which the investor is sensitive and potentially exposed. This could include allocations away from equity or nominal bonds, in favour of defensive hedge funds, senior private debt or real assets with contractual income streams. Low-volatility equity and sub-investment grade credit might be more defensive than broad equity market exposures, but both would probably be highly correlated with equities in a crisis.
- Additional flexibility: Cash may have a role to play in reducing the risk of having to crystallise losses to meet cash output requirements or collateral calls in stressed conditions, while also acting as dry powder, offering the ability to re-deploy assets at more attractive levels. The latter activity will be available only to investors with a strong governance process and a willingness to act in a dynamic fashion. Investors wishing to delegate this dynamic asset allocation activity might consider idiosyncratic multi-asset strategies or multi-strategy hedge funds.
Investors face a market environment offering the prospect of lower returns and fatter tails. Portfolios dominated by broad market equity and bond exposures are likely to face significant headwinds, not just in terms of the level of returns achievable, but also given the potential for a shift in equity-bond correlations.
In short, sovereign bonds proved helpful during the financial crisis but investors can no longer rely on bonds bailing them out in the next market meltdown.
Phil Edwards is global director of strategic research at Mercer.