Current inflation is upending 20 years of the conventional approach to portfolio management, where a mix of often 60% stocks and 40% bonds should help investors earn a nice return, without too much risk.
For most of these two decades, such an approach has been deemed sensible and the average correlation between American stocks and Treasuries has been negative at -0.5. However, for the first four months of 2022, long-term U.S. Treasury bonds were off -18% while the stock market dipped into the bear market territory.
Equity and bond market returns tend to have opposite exposures to economic growth news, but directionally similar exposures to inflation news. It follows that the stocks and bonds correlation is pushed negative on the news of economic growth, and pushed more positive in an inflationary environment. However, on August 10th American inflation data indicated prices did not rise in July, but stocks jumped, - the S&P 500 rose by 2.1, and short-term Treasury prices climbed, too.
According to experts, if the correlation between stocks and bonds shifts from -0.5 to +0.5 the volatility of a “60/40” portfolio increases by around 20%.
Some investment professionals estimate the phenomenon of a shift toward a positive correlation between stocks and bonds could continue for many years and be widespread across all global markets. Among the influencing factors are “broad macroeconomic themes like fiscal sustainability, the degree of perceived monetary independence, the degree to which supply or demand is driving the economic cycle, and investor sentiment. These policy and economic conditions connect very intuitively to…stock-bond correlation,” Dr. Noah Weisberger, a managing director in PGIM’s Institutional Advisory and Solutions (IAS) group said to IPF Investor.
To avoid being misguided it may be very worthwhile for investors to rethink their approaches and adjust their portfolios to the new reality. A New York-based private asset-management firm KKR in its recent paper argues that illiquid alternatives, like private equity and credit, are a good way to diversify. An investment management firm AQR from Connecticut suggests stock-matching strategies such as “long-short” equity investing where success has little to do with broader economic conditions.
Our partnering company in asset management Sigma Global Management is also convinced that the long-short, market-neutral, volatility-based approach provides investors with stable, positive returns even in times of a market crisis and decline.