This article was first published in the Institutional Investor on 14 May 2021 here.
Negative correlation between equities and bonds – the cornerstone of hedging and diversification in many institutional portfolios – might be in jeopardy.
For several decades, investors have relied upon the negative correlations between equities and sovereign bonds to provide a hedge against inflation – almost as if the contrary relationship between the two instruments were an immutable aspect of market behavior. Historically speaking however, the correlation between stocks and sovereign bonds has been primarily a positive one, turning negative a little more than 20 years ago.
That the negative correlation is an anomaly over the long term doesn’t really matter, according to Philip Seager, Head of Quantitative Investment Solutions, at Capital Fund Management (CFM). What does matter, he says, is that investors “may be unaware it could change and are not prepared for that possibility.”
Should the negative correlation flip to a positive one, the culprit will likely be inflation – or more specifically, “whether the market perceives it to be under control,” says Seager.
There is a general expectation that inflation will accompany the reopening of economies in the U.S. and Europe, where significant monetary and fiscal stimulus policies have been enacted. Stimulus checks have put money directly into the accounts of the populous and provided grants and loans to businesses, and the Biden administration is poised to invest in infrastructure and green projects. In Europe, the Next Generation EU plan is part of the largest economic stimulus package ever seen on the continent.
Also contributing to potential inflation are the accumulating savings of unspent stimulus checks, and supply chain bottlenecks that have been rampant since the outbreak of the Covid-19 pandemic and show no signs of abatement. Supply and demand shocks are realistic possibilities. In short, a pick-up in inflation is likely. The big question is: will it be permanent or transitory?
“The Fed is notably more comfortable with higher levels of inflation, targeting an average of 2% – rather than absolute level of 2% – since summer 2020,” says Seager. “The potential impact of that isn’t precisely known, but it could lead to a rise in inflation assumed to be transient with the expectation that it will return to 2% over the long term. The market is pricing break even inflation at 2.5% at 5 and 10 years out.”
Perception is the watchword, however, and Seager points out that it’s possible to assume a surge in inflation is temporary when it isn’t. There are several factors that could contribute to a bout of inflation with more staying power.
“Broader money supply measures show that stimulus has made its way into the real economy, unlike during the global financial crisis of 2008-09,” says Seager. “It’s also possible that as previous instances of inflation recede farther into the past, central banks could be complacent and perhaps overly comfortable in a scenario they think is a temporary surge but proves to be the opposite. Fiscal stimulus measures may close the output gap, especially if the economy is damaged to the point that capacity is lower and more quickly reached. Anti-globalization and anti-immigration policies in some major economies could mean less and more expensive labor and tariffs that increase the price of imports. In the U.S., there has also been talk of nationalizing supply chains, and that could raise the price of goods.”
An eye toward behavioral shift
With the post-gold standard move towards fiat currencies and a fractional reserve system at the start of the 1970s, inflation was initially difficult to tame. It took until the late 1980s and 1990s for central banks to begin to successfully keep inflation levels under control. It was then, around the turn of the century, that the positive correlation between equities and sovereign bonds flipped quite brutally, coinciding with the Asian crisis that unfolded in October 1997. Inflation expectations dropped to below 3%, from above 5% less than a decade earlier. Believing central banks had successfully brought future-return-eroding inflation under control, investors deemed sovereign paper a legitimate store of value – especially in times of severe equity market distress.
“This was akin to a behavioral shift on the part of investors, and sovereign paper could now be sought as a defensive investment if and when concerns about future equity returns flooded the market,” says Seager. “For their part, investors were confident that, if need be, monetary policy could be loosened safely without stoking inflation. Our argument today is that if the flip to negative correlation at the end of the ‘90s was behavioral, then the flip back can also occur if investors no longer believe that central banks can provide easing without stoking inflation. Inflation is unambiguously bad for bonds. Which way equities go is more difficult to know”
Such a flip would undoubtedly reverberate across the assent management industry. The 60/40 index has become a key element of traditional investing and many pension funds also hold big portfolios of equities complemented with bonds as a hedge. That hedge – defined as holding an instrument negatively correlated with equities – is crucial.
“Risk adjusted returns are clearly superior when bonds are anti-correlated. The anti-correlation leads to a reduction of risk for the same level of return. In addition, over the past 20 years bonds have successfully protected the negative tails of equity returns, meaning the worst daily and cumulative returns of equities have been accompanied by the best daily and cumulative returns of bonds,” says Seager.
Being prepared for the potential big flip
It isn’t certain, of course, that a tipping point will be reached where inflation pushes the negative correlation to positive. However, based on price data there is some evidence bond and equities are already moving in sync – and that presents a challenge for the entire asset management industry.
Seager posits that perhaps “with the evolution of inflation it’s possible to forecast a move in correlation towards more positive territory.”
To that end, Seager and his colleagues at CFM have been thinking about how they might incorporate the potential for a correlation flip into their risk modeling – and as they construct portfolios, they are also looking to reduce sensitivity to the past correlation.
“We run long/short portfolios of equity index and bond futures,” says Seager. “The risk of the portfolio depends on the volatility of instruments and the correlations between them. If the regime changes, and the bond/equity correlation becomes positive, it changes the risk of our portfolio. To see how that might play out, in the risk modeling process we are shocking the portfolio to a change in correlation. We also need to ensure we don’t build leveraged positions – long/long or short/short – that we think are low risk but are actually high risk in a regime shift.”
In more traditional portfolios, Seager believes investors should look more closely at using bonds in combination with their equity allocations. Bonds are potentially no longer offering a hedge, nor even much of a diversifier (zero or slightly positive correlation).
“The future return streams of bonds look poor with rates at historical lows and inflation eating into the fixed payments,” says Seager. “At CFM we have built cheap defensive strategies based on trend following and VIX futures – cheap in the sense that the negative drag associated with option protection is absent, and defensive meaning they have anti-correlated performance in the biggest negative returns of equities.”
Diversification can be obtained with many types of macro style strategies, says Seager, as long as care is taken there is not an embedded equity premium. That’s why at CFM back-testing is used as a guide to try to understand the mechanics of strategies.
“Even if the long back-test does not reveal a correlated tail, it is better to understand what is driving a strategy’s returns and whether there could potentially be a correlated tail in the future,” says Seager.
A final area of study for the team at CFM is focused on how to hedge inflation and building portfolios that remain robust in the face of it. It’s a work in progress, according to Seager.
“We feel that trend following may also be a cheap hedge against inflation-related surprises – cheap relative to a traditional hedge such as TIPS that make money in a high inflation regime, but which have a negative drag if the high-inflation scenario doesn’t pan out.”
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