The return of inflation as a significant problem in 2022 has triggered significant losses in the bond and stock markets, and although it has since declined from its peaks, Gopi Karunakaran believes that inflation uncertainty remains high and could lead to retaliation from the 2022 environment.
“High inflation uncertainty has changed the bond/stock correlation, making it more volatile and, more often than not, a positive correlation. As inflation uncertainty is likely to persist for some time, we can characterize this change in correlation behavior as a regime shift rather than just a temporary disruption,” he said.
According to Karunakaran, this regime change impacts the traditional role of long-duration government bonds as a safe haven, as it makes bonds less reliable and less effective as a defensive risk diversifier for stocks.
“Bonds play their safe-haven role most effectively when they have both low volatility and low correlation to stocks. The regime shift to a more uncertain inflation environment has made bonds more volatile and made the bond/stock correlation more variable,” he said.
This, however, does not mean that long-duration government bonds are no longer useful as a means of diversification, Karunakaran said, noting that they can still be useful in certain scenarios, including economic growth shocks.
But given that the reverse is also true, he stressed that “relying on long-duration government bonds as the only means of diversifying equity risk is not a good idea.”
“The takeaway is that portfolio construction should not rely too heavily on long-duration government bonds as a defensive diversifier from equity risk,” Karunakaran said.
“Relying solely on the sole lever of duration to diversify equity risk integrates an implicit macroeconomic forecast on the types of macroeconomic scenarios likely in the future. This [is] a risky bet to make given the unreliability of macroeconomic forecasts in general, and particularly in regimes of high inflation uncertainty.
An alternative approach, he noted, is to reduce reliance on macroeconomic forecasts by focusing instead on building portfolios that are resilient to a wide range of possible outcomes.
“This means expanding the risk diversification toolbox to complement conventional duration leverage with other investments that have the following attributes: low downside volatility, low correlation with equity markets, strong defensive bias for outperform when equity (and bond) markets suffer losses, an attractive stand-alone approach. risk/reward profile (positive expected return from true alpha),” Karunakaran said.
Highlighting “consistency of behavior” as key, he added: “It doesn’t do much good to have a risk diversification portfolio that exhibits these attributes in good times but looks like stocks in bad moments.”
“It’s like an umbrella that only opens on sunny days… it’s not fit for purpose.”
“Reliable risk diversification involves adding investments whose underlying return drivers are genuinely different from the factors that drive stock returns, especially in extreme scenarios. »
But Karunakaran warned investors to also be wary of investments labeled “alternative,” noting that while some may appear “different enough” from stocks on the surface, in reality they can end up behaving like stocks when markets fall.
“Therefore, it is important to look beyond the labels and understand the true underlying drivers of an investment’s returns, as well as how these factors are likely to impact performance in different scenarios stock market.”
