Changing tides in the capital markets
How beautiful the investment world of yesterday was: equity and bond markets both delivered above-average returns, on top of that, the combination of both asset classes delivered very good diversification due to negative correlation. A simple 60/40 portfolio was therefore sufficient to generate attractive returns; and with that low volatility. However, due to recent strong monetary expansions, rising commodity prices and disruptions in global supply chains, investors are now faced with the challenge of rebalancing their portfolios to account for increased inflation risk. This is uncharted territory for many portfolio managers: after all, inflation has not been a serious issue since the 1980s.
The first half of 2022 should therefore have been a wake-up call for many market participants: The classic portfolio, consisting of 60% equities and 40% bonds, suffered the heaviest losses since 1932 due to simultaneously falling equity and bond markets: Around 16% price loss was recorded at the mid-year.
The simultaneous collapse of the equity and bond markets in the first half of 2022 resulted in the largest price loss for the 60/40 Portfolio in several decades.
Source: TradingView
Rising inflation uncertainty affects many areas
In macroeconomic terms, the new inflation regime is having a whole host of effects: On the one hand, high or strongly fluctuating inflation makes it more difficult for households and companies alike to distinguish absolute price changes from relative price changes, which increases inflation uncertainty. The general level of interest rates and the volatility of interest rate developments increase as a result. With greater uncertainty about future inflation developments, monetary policy becomes less predictable for both market participants and economic agents. The risk of a negative monetary policy surprise thus also increases. Due to these factors, uncertainty about economic growth consequently also increases, which ultimately leads to lower GDP growth. A look back at the 1970s, which were characterised by stagflation, shows that the buy-and-hold strategy, which worked well in the past, may no longer work. Instead, active timing and asset class rebalancing may be called for.
Source: TradingView
Comparison of returns of traditional and alternative asset classes
Historical data shows that periods of high inflation and elevated inflation expectations have a major impact on capital markets, especially if the trend persists over an extended period of time. A comprehensive study compares annualised real returns for each asset class and active strategies during periods of high inflation and other periods. The results for the period from 1926 onwards speak a clear language:
- Traditional investments perform poorly in inflationary phases [1]
- On average, equities generated an annualised real return of -7%
- Ten-year government bonds delivered an annualised real return of -5% on average
- A 60/40 portfolio achieved an annualised real return of -6% on average
Figure 3) Asset and strategy performance in inflationary and non-inflationary periods (USA).
Traditional asset classes deliver negative real returns in inflationary periods. In contrast, active strategies such as trend following and alternative assets such as commodities benefit.
Source: Henry Neville, Teun Draaisma, Ben Funnell, Campbell R. Harvey, Otoo van Hemert "The best strategies for inflationary times".
The development of alternative investments and active strategies, on the other hand, is quite different. Commodity investments in general have a significantly positive inflation beta and delivered high real returns in times of high or rising inflation. This is especially true for energy commodities - a development that can also be observed in the current market situation. Among active strategies, trend-following strategies performed well, based on all asset classes. This is due to the fact that inflation shocks do not mark overnight events but rather longer episodes and thus provide a good basis for trend-following models.
How does the equity-bond correlation react to increased inflation?
It is not only the weak performance of traditional assets that causes investors headaches in inflationary phases - there are also unfavourable shifts at the correlation level that affect the risk-return ratio of the portfolio. The following chart shows the rolling correlation of the two most important asset classes, equities and bonds, during three periods:
- Between 1950 and 1965, the correlation between equities and bonds was -0.16
- Between 1965 and 2000 the correlation increased significantly to +0.28
- In the two decades between 2000 and 2020, the correlation fell again significantly into negative territory (-0.29)
Phases with higher inflation rates cause the stock-bond correlation to shift from negative to positive territory. The diversification effect thus decreases significantly.
Source: PGIM Quantitative Solutions [2]
The increase or decrease in the correlation between equities and bonds depends on numerous factors. Phases such as those from 1950 to 1965 and 2000 to 2020 were characterised by low and stable inflation rates and the risk-free interest rate. From the monetary and fiscal policy side, a certain predictability and continuity could be observed. All these factors provide for a negative correlation between equities and bonds. The reverse development, however, provides for a shift of the correlation into positive territory: surprises from the monetary policy side, unsustainable fiscal policy, increased and volatile inflation and interest rate levels as well as shocks on the supply side.
The increase in the correlation between equities and bonds ensures higher volatility in the portfolio due to the weaker diversification effect and thus a lowering of the Sharpe ratio. Figure 5 shows schematically how the Sharpe ratio changes on the basis of the different correlations and the respective bond weighting.
The higher the bond weighting, the more the Sharpe ratio of the overall portfolio falls when the correlation shifts from negative to positive territory.Note: The performance of the portfolio is based on 1000 simulated monthly returns with monthly rebalancing. It is assumed that equity and bond returns are normally distributed. Expected annualised returns: Equities 10% p.a., bonds 5% p.a., annualised volatility 12% and 6% p.a. respectively.
Source: PGIM Quantitative Solutions [2]
Hedge funds as a source of diversification and returns
Low return prospects and adverse changes in the correlation between and equities and bonds are increasing the pressure on the classic 60/40 portfolio - not least due to the historical slump in the first half of 2022. The fact that the majority of portfolios have a downside inflation bias, i.e. tend to benefit from low or falling inflation rates, represents an open flank for the future. In order to be able to guarantee future return targets at an acceptable risk, it is therefore worth looking at alternative investments such as hedge funds.
