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Inflation dynamics flipped the traditionally negative equity-bond correlation on its head in 2022, creating headaches for investors with 60/40 portfolios. We believe this was particularly painful for ‘lower’ risk investors who typically had greater duration in what are often described as ‘risk-free’ assets such as government bonds. While the equity-bond correlation became negative again at various points throughout 2023, we have also continued to see sell-offs where both asset classes move in tandem. These periods are often characterised by a shift towards the ‘higher-for-longer’ inflation narrative and hawkish central bank moves that are likely to reoccur if inflation remains volatile.
Some commentators, having observed these recent trends, proclaimed the death of diversification, yet we would caution against such a blunt approach. Much like with the succession of a new monarch, when one era ends there will be some degree of change, but the underlying principles on which the institution exists tend to endure. We believe this is a relevant metaphor to the principles for investing, so while investors may need to rethink their approach to diversification, it would be unwise to ditch it altogether, in our view.
A diversification dethroning?
From the early 1990s until 2021, the correlation between equity and bond returns had typically been negative. That changed last year. In 2022, all asset classes except cash and commodities delivered a negative performance. Why the change, and is this the new normal?1
The equity-bond correlation is typically driven by economic shocks. Aggregate demand shocks tend to drive cashflow expectations and discount rates in the same direction. Generally, bond and equity prices tend to be inversely correlated in response to such shocks. In contrast, aggregate supply shocks tend to drive inflation up and output down. For a nominal bond, higher inflation would reduce the value of its cashflows, likely also resulting in a fall in bond prices.
In our view, the correlation between equities and bonds will be determined by which of these shocks dominates, and history has demonstrated that bonds have remained one of the most reliable assets to help fortify portfolios in a recessionary environment, as the below table demonstrates.
This is why the question of whether we are in a temporary period of high equity-bond correlation, or a structural ‘new era,’ is important. On balance, we lean towards the former, but acknowledge some more structural inflationary factors that could mean we won’t fully return to the golden age of equity-bond correlation.
Heavy is the head that wears the equity crown
With the stability of the equity-bond correlation thrown into question, we must place an even greater level of scrutiny on the level of diversification within each asset class. We believe this is particularly important within equities, as not only does the asset class often account for the largest component of risk within a portfolio, but there are also concentration risks within equities that are particularly acute.
Over the course of the past decade or so, we have seen the weight of US stocks in global developed market (DM) equity indices increase significantly. As illustrated in the below graph, this means that US equities now make up roughly two-thirds of global DM equities.
Source: Bloomberg as at 30 June 2023. Past performance is not a guide to the future. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested.
Source: Bloomberg analysing annual returns between 1987 and 2022. Comparison of MSCI Gross Return Indices for North America, UK, Europe, Japan, Asia ex-Japan and Emerging Markets. Past performance is not a guide to the future.
If we were to allocate to DM equities based on market capitalisation, this would lead to roughly two-thirds of our developed market equity allocation being invested in one region. Beyond simply looking at market capitalisation, we do not believe there is any reason that this should be our starting point when constructing a portfolio.
Strong relative performance from US equities has led to this large weighting in the index, but we do not believe this will necessarily be sustained in the future. As the below chart shows, the US has been the best-performing region globally for much of the past decade, but this was not always the case. In fact, there were several years historically where it was the worst-performing region.
Additionally, we have long been worried about the stock concentration level in US equities. As the below table shows, the top five stocks in the S&P 500 Index now make up around a quarter of the index. This means that the largest stocks in the index now drive an inordinate proportion of its returns.
Source: Bloomberg, as at 31 December 2022. The value of any investment and any income taken from it is not guaranteed and can go down as well as up, and investors may get back less than the amount originally invested.
We find this market dynamic uncomfortable and are unwilling to allow a few stocks to have such a meaningful impact on the outcomes of our portfolios. We therefore seek to favour a more diversified approach within our regional equity allocations, meaning we typically have more exposure to other DM regions than our peers, and less exposure to US stocks.
This isn’t to say that we are predicting the US will do badly, or that the largest companies will disproportionately underperform; it’s just accepting those risks exist and that if we diversify more by region, sector and company we can combat that concentration conundrum and aim to deliver a more balanced portfolio over the longer term.
A Royal sterling flush
Currencies can also play a role in diversifying portfolios. We think of sterling as an intermediate risk currency, being riskier than the US dollar, yen and euro. This means we believe that sterling is more likely to sell off in a crisis and that holding foreign currencies can lessen some portfolio risk.
Consequently, we prefer less overall hedging for sterling portfolios compared to euro, US dollar or Swiss franc investors. Beyond the global market risks, foreign currency exposure can help to shield against domestic risks that investors are typically exposed to. We believe that such exposure is another diversification tool we have at our disposal as portfolio managers.
Correlation coronation
We strongly believe that the principles of diversification within multi-asset portfolios hold true just as much now, as they have done over the last few decades. However, we appreciate that cross-asset correlation will likely behave differently in the current market regime, when compared with the post global financial crisis decade of benign growth and inflation.
As such, we must work harder to understand potential concentration risks and seek out appropriate levels of diversification across the entire portfolio.
While diversification may no longer operate in the same way as during the last decade, we strongly believe that its inherent principles live on in this new market regime.
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Key Risks
It should be noted that diversification is no guarantee against a loss in a declining market. The value of investments and the income from them can go down as well as up and you may not get back the amount invested. Past performance is not a guide to future performance.
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