The correlation between equities and bonds moved positive for the first time for 20 years in 2022, with potentially profound implications. This introduces a rationale for non-traditional (‘alternative’) allocations, argues Waverton fund manager Luke Hyde-Smith.
While the return of the 60/40 model may seem compelling, and indeed many investment managers have moved out of their alternatives allocations in recent months, we contest that investors must remain mindful of the structural changes reshaping the financial landscape.
The transition from financial repression to policy normalisation, coupled with higher inflation, greater interest rate volatility, larger government deficits, higher starting debt levels and elevated market concentration, will continue to challenge the assumed diversification benefits of traditional equity-bond correlations in the coming years.
Periods of higher market concentration and higher interest rate volatility have historically meant higher correlation between equities and bonds. As Morgan Stanley note, “if we go back to the positive correlations that persisted from 1970 to 2000, the challenges to achieving easy diversification will likely increase, producing more volatile portfolio return patterns and increasing the attractiveness of alternative and uncorrelated asset classes like hedge funds and private investments.”
Figure 1 highlights the correlation between bonds and equities, appearing to move increasingly positive once inflation is 2.5% or higher. The dark blue dot is the latest observation.
Figure 1
Note: Rolling 36 month Correaltion between the 1 month S&P 500 Total return and the 1 month 10 Year US treasury Return, versus the 3 Year Core Inflation Rate.
Source: Minack, Bloomberg, Waverton. Data from December 1985 – January 2025.
This has important implications for portfolio construction. In a world of sub- 2% inflation, which has characterised the investment environment since the late 1970’s, and thus the majority of current investment practitioners lifetimes, government bonds have provided excellent portfolio diversification in times of equity market weakness. However, the experience over 2022 is a reminder that this relationship is not a constant and cannot be relied upon on an ongoing basis, especially if we are entering a higher, more volatile, inflationary regime.
Indeed, looking at the long term, using Professor Shiller data, one can argue that the last 20 years of persistently negative correlation between equities and bonds is more of an outlier than a constant. This moved positive for the first time for 20 years in 2022, with potentially profound implications.
Figure 2: Historical perspective on equity bond correlation. Long-term 3-yearr correlation between US Treasury and S&P 500. Shiller Data. 1872-2024.
Source Shiller, Waverton. Data to December 2024
Such an increase in equity-bond correlations has implications for the diversification benefit of owning the traditional 60/40 portfolio of just equities and bonds, and introduces a rationale for non-traditional (‘alternative’) allocations. That is; by owning non-traditional asset classes, investors can increase diversification and thus lower portfolio volatility over the forecast time period.
Should we be entering an environment more akin to the historical norm, then investors would be well advised to consider investments that both hedge a higher inflationary outcome, such as Real Assets, but also consider strategies that deliver returns independent from both equites and bonds, such as Absolute Return strategies.
We have recently witnessed two consecutive years of strong performance in global equities (led by the US) and credit spreads are tight versus their historical range. This has resulted in public market valuations, in certain areas, well above their long-term averages. This creates challenges for investors and poses a key question for asset allocation.
What can enhance potential returns, improve diversification, and mitigate volatility?
Our answer is twofold, an allocation to both Real Assets and Absolute Return strategies.
We split the alternative investment universe into return-seeking and capital-protecting alternatives; Real Assets and Absolute Return. Within Real Assets, we include property, infrastructure (including new energies), commodities, asset finance and specialist lending (the latter providing debt capital across different underlying real assets). Within Absolute Return, we segment the allocation into three buckets: specialist fixed income, structured opportunities and third-party absolute return strategies.
Real Assets
Real Assets are predominantly businesses backed by physical assets, and /or generate highly predictable, often inflation-linked cash flow streams, that can be capitalised. We define Real Assets as long-only, return-seeking alternatives, intending to generate an equity-like return over the long term from differentiated return sources to equity beta and bond duration.
This is a broad and diverse universe, however the sub-asset classes share some common characteristics, including:
• Linked in varying degree to global growth and therefore likely to post rising returns in a positive economic environment.
• Inflation-linked cash flows, thus providing some protection in an inflationary environment.
• Cash flows delivered via coupon or dividend, providing an attractive level of income.
• To date, lower mainstream investor participation, providing a relative value opportunity and helping meet a number of the challenges facing traditional portfolio construction.
Absolute Return
For lower risk clients, the traditional large percentage allocation to fixed income as a defensive asset has been severely challenged over the last three years. Our belief, as evidenced by performance outcomes, is that a range of diversifying assets, across specialist fixed income, absolute return strategies and structured opportunities can provide defensive properties in both an equity market drawdown, but importantly in a challenged fixed income environment where returns may continue to be lacklustre.
We are acutely aware of the need for this exposure within portfolios to not only provide downside protection and diversification but upside participation and generate nominal returns over and above what is available in short term cash deposits.
While global government bond markets may have short-term appeal from the lower inflationary backdrop, long term, there are plenty of reasons to remain wary of the US treasury market. Indeed, there are concerns being voiced in the market whether the U.S. heading for a “Liz Truss Moment?”, given rising apprehension about the U.S. fiscal condition.
We therefore undertook extensive bottom up, forward looking, risk and return analysis to determine what investors should expect from this allocation and how best to optimise for an attractive return profile. This is detailed in Figure 3.
Figure 3
Source: Waverton
A higher macro-economic volatility regime and greater stock dispersion, due to less concentrated equity market returns, also provides more opportunity for bottom-up alpha generation, both on the long-only side and long short. For alternative absolute return strategies, term premia and the higher cash rate will further support returns, supporting the 7% expected return from this exposure.
Conclusion
High valuations, concentrated equity markets, and the unstable correlation between public bond and stock performance have, in our view, eroded the diversification benefits of a traditional 60/40 portfolio construction, leaving investors more exposed to systemic risk, especially during periods of market stress. By considering an allocation to a broad range of alternatives, investors can gain access to an expansive and increasingly diverse universe of investment opportunities. The Waverton Balanced MPS currently has 12.5% in Real Assets, and 7.2% in Absolute Return.
Finally, it is important to highlight that the unique nature of the Waverton MPS on Platform, using the ‘building block’ approach, allows the investment team to select investments across a broad range of investment structures, which are not available in aggregate on platform. While daily dealing real estate funds and many UCITS absolute return strategies that are available across a broad range of UK platforms within the alternatives space have failed to meet investor expectations, you will not find these investments held within the Waverton MPS.
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