Volatility is back. One of our key themes at the start of this year was that we would be moving from an unusually subdued volatility environment to something more normal for this stage in the cycle. Through the whole of 2017, the S&P 500 Index moved by 1% or more only 10 times. Since the start of February, it has done so 17 times.
The volatility in early February was triggered by unexpectedly high US hourly earnings growth. We had another jolt last week, and this time you could pick your catalyst. Flash Purchasing Managers Index reports were softer than expected. Technology stocks were under attack because of concerns about data security. President Trump upped the ante on trade on Thursday with his tariff plans for Chinese imports. And the day before, markets were unsure what to make of a less-hawkish-than-expected debut by Fed Chairman Jerome Powell.
Whichever catalyst you pick, the more important point to recognise is really the same as the one in February: Volatility has returned to markets, so what can investors do to buffer their portfolios from it?
Usually, the answer involves balancing equity risks with a good dose of interest rate risk from core government bonds on the assumption that these two risks are negatively correlated. Our new environment may be characterised not only by higher interest rates, higher inflation and higher volatility, however, but also by higher correlations between equities and bonds.
Correlations are cyclical
Since the financial crisis, investors have benefited from low to negative correlations between the two largest asset classes. They have enjoyed the free lunch of being able to diversify the downside risk in their equity portfolios with developed market government bonds.
Over the longer term, however, stock-bond correlations have been modestly positive, with cyclical characteristics. Correlations tend to be negative during periods of low growth and low inflation, and positive during periods of higher economic growth and inflation. That positive correlation has tended to hit its highest levels toward the end of the business cycle, when central banks attempt to cool down the economy by tightening monetary policy.
If our view is correct, and we are entering a period of somewhat faster rising prices and tighter policy, history suggests that asset allocators may not stand to benefit as much from the low-correlation free lunch. An early taste of this came during February, when the S&P 500 Index fell by 3.7 per cent and the Bloomberg Barclays US. Aggregate Long Treasury Index was down by 3 per cent. In our new environment, government bonds may no longer provide a strong buffer during a bout of volatility.
As correlations rise, diversification becomes a challenge
We now need a more thoughtful approach to managing risk and achieving portfolio diversification. There are various ways to go about this, but we see three straightforward approaches.
The simplest is to reduce overall risk levels across portfolios. A keynote of our recent thinking has been the readiness to adopt less volatile and less market-sensitive positions in traditional asset classes. That might involve moving into higher-quality companies in equities and credit, or exchanging some straight equity exposure for the lower-volatility alternative of put option writing.
The second approach is to seek out other markets that diversify away from equities but do not carry the same risks as bonds. In the later stages of the business cycle, inflation-sensitive assets such as TIPS, global inflation-linked bonds and commodities have tended to perform well. Floating-rate investments such as loans may also provide a shelter.
The third approach is to seek out investments that are not correlated to traditional market risks at all. Examples might include uncorrelated, low-volatility hedged strategies or strategies that seek to harvest multi-asset class risk premia.
A sensible course might be to blend some aspects of all three approaches. When government bonds are no longer an effective anchor to windward, investors are challenged to find ballast for their portfolios to keep them upright without weighing them down.
— Erik Knutzen, Chief Investment Officer — Multi-Asset Class, Neuberger Berman
