This Time Is Different (Really)

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Three months into 2022, and we appear to have entered an environment that investors allocated exclusively to traditional assets have long feared. The presumed diversification of an asset allocation mix of long-only, publicly traded stocks and bonds may be breaking down.
 
Whether that stock/bond relationship (which has been negatively correlated for the better part of two decades), has cyclically shifted or structurally changed will be determined over the coming months and years. But with equity valuations still expensive by most historical metrics, interest rates heading higher, and credit spreads still tight, there is certainly an argument to be made that this breakdown reflects the start of a new market paradigm.
 
The implications of such a structural shift would be significant. If the model 60/40 equity-and-bond allocation can no longer provide the key ingredients of a well-constructed portfolio—capital appreciation, downside protection, and portfolio diversification—investors will have to rethink and reshape their portfolios.
 

Heads you lose, tails you lose

As Exhibit 1 highlights, equities and bonds across the spectrum in the United States have moved downward in concert so far this year.

Depending on the composition and balance of risk across an investor’s stock and bond investments, a traditional asset-only portfolio is likely down 5% to 7% already this year—and that includes a 10% rebound in equities at the end of the first quarter.

Appreciating the myriad uncertainties we are currently facing, it seems safe to assume a few things from a market perspective:

• The risk of a slowing economy, exacerbated by the need to increase rates, presents a fundamental challenge for stocks and bonds.
• Market dynamics like higher volatility and greater uncertainty, on a company-specific and macroeconomic basis, are likely to remain in focus moving forward.
• If stocks and bonds remain positively correlated, each leg of the stool that comprises a well-constructed portfolio—capital appreciation, wealth preservation, and portfolio diversification—may be weakened.

This time it might be different, if not unprecedented

Like all advisors that allocate client capital in global markets, we are always thinking about historical parallels to help contextualize current market conditions. At the same time, we fear those famously dangerous words, that “this time it’s different.”

Appreciating the recency bias, it is interesting to examine each double-digit drawdown period for global equities dating back to 2000 to assess how bonds performed, in terms of protection and diversification.

Prior to the onset of the COVID pandemic, the average global equity decline during a correction was just over 20%, during which periods bonds generated a positive (2.6%) return (see Exhibit 2). However, that relationship did not hold in early 2020, when a 20%-plus fall in global equities was paired with a slight decline in bonds. During the sharp double-digit decline that kicked off 2022, bonds sold off by more than 400 basis points.

So, the key question is whether this is simply anomalous, or potentially persistent?

There is certainly historical precedent for stocks and bonds moving in concert. There are multiple environmental factors that drive the correlation of traditional assets in the United States.¹ Our analysis of the correlation of historical U.S. stock and bond performance highlights the long-term shifts in this relationship (See Exhibit 3).

Using 10-year rolling correlations, we show that a market paradigm of negative stock-bond correlation has (or had) only been in place since early this millennium, and previously for around 20 years from 1950. These two distinct periods share several traits, including low and stable risk-free interest rates, combined with low and stable inflation.²

By contrast, for roughly three decades up to around the turn of the millennium, stocks and bonds generally moved in the same direction. During this period, the U.S. economy exhibited the inverse conditions, principally high and variable risk-free rates and high and variable inflation, though there were other economic and policy drivers.

Should the start of this year prove to be a leading indicator for market conditions, rather than a passing phase—and it is too early to be certain which of these it is—it becomes quickly evident that what worked well over the last two decades will not necessarily work moving forward. Stocks and bonds may not alone be able to fulfil the key portfolio goals of return generation, capital protection, and diversification.

Time to broaden the toolkit?

If this truly is indicative of a new market paradigm, we are entering uncharted territory for many advisors. A new mindset and a new set of tools will be required to adequately handle a higher volatility market regime. Finding ways to not just manage but actively exploit these new market trends via alternatives will likely become increasingly important to meeting clients’ long-term goals.

This may include certain “non-directional” fixed income strategies, such as relative value arbitrage, that are less dependent upon the trajectory of the overall bond market but are instead focused on exploiting its inefficiencies. We also see opportunities to diversify fixed income allocations in private credit, private real assets, and structured products.

The “recorrelation” toolkit

1) Private credit

Traditional fixed income is suffering under the “quadruple threat” of rising rates, higher inflation, low bond yields, and tight credit spreads, creating significant problems for advisors dealing with the “40” in a standard stock/bond portfolio allocation. The first quarter of 2022 highlighted this dilemma, with investment grade bonds down over 8% to start the year.³

Private credit provides exposure to floating-rate securities, often secured and senior in the capital structure, with stable total returns, attractive yields, and defensive attributes to help protect against defaults.⁴ Additionally, private debt can also provide diversification benefits, offering further value in client portfolios. Direct lending, for example, which is dominated by private, non-bank lenders,⁵ has been negatively correlated to the aggregate bond index for nearly two decades (see Exhibit 4).⁶

2) Relative value arbitrage

Relative value arbitrage seeks to take advantage of the fundamental or statistical relationship between different securities and, unlike long-only stocks and bonds, greater uncertainty and rising volatility creates non-correlated, return-generating opportunities.⁷ Absent volatility, asset prices tend to be highly correlated, and the arbitrage spread is narrow. Greater volatility causes those spreads to trade in a wider band, providing more opportunities to find value in market mispricing and inefficiencies, and thereby offering a tailwind to strategies like merger, convertible bond, and equity arbitrage, along with fixed income relative value and volatility trading. Further, the exponential increase in new equity, credit, and convertible bond issuance,⁸ and record merger volumes,⁹ provide fertile conditions for relative value arbitrage, which takes long and short positions in securities to offer capital appreciation opportunities with downside protection.

3) Real Assets

Investments in private real estate, timber, farmland, and global commodities can offer compelling yields,¹⁰ diversification, and exposure to potential “long volatility” strategies, complementing the traditional long-only portfolio construct.

Core real estate, for example, offers stable, predictable income through long-term contracts that generate regular cash yield for investors.¹¹ Timberland investments also provide income,¹² with returns that are basically uncorrelated to either stocks or bonds.¹³ The energy and mining sectors are direct beneficiaries of commodity price inflation,¹⁴ and therefore may serve as defensive allocations when rates rise and many traditional assets decline, as both stocks and bonds did in the first quarter.

4) Structured products

Structured products are designed to offer both capital protection and yield enhancement. Capital protected instruments come in two forms: market-linked notes, which are a type of bond with a senior but unsecured credit profile, or FDIC-insured certificate of deposits.

In both instances, the notes provide investors with the opportunity to benefit from the performance of an underlying reference asset, while protecting capital at maturity from a decline in the asset’s value. Yield enhancement instruments allow investors to benefit from rangebound (i.e., relatively flat) markets by combining conditional downside protection down to a pre-set barrier level, along with partial upside participation via a fixed coupon that typically offers a higher yield than the standard interest rate market.¹⁵ If the reference asset’s price declines beyond the established barrier level, the investor is, however, fully exposed to the negative performance of the underlying asset, just as they would be with a direct investment.¹⁶

Conclusion

As ever, appropriate investment selection depends entirely on an investor’s goals and risk and illiquidity tolerance, among many other factors. But for advisors concerned that the shift in stock-bond correlations may reflect a new market reality—particularly in the context of a volatile macroeconomic environment and heightened geopolitical risks—alternatives seem likely to become increasingly necessary components of a portfolio that meets clients’ financial goals.