by Christoph Schon, CFA, CIPM
Standalone equity volatility in Qontigo’s global multi-asset class model portfolio has dropped by a third since the beginning of February—yet the current predicted risk for the total portfolio of 6.6% is only marginally lower than the 7.2% of 11 weeks ago. The main reasons for this are that share and bond prices are no longer negatively correlated, while the recent dollar weakening has once more amplified the returns of non-US stocks.
The fact that sovereign yields have been moving mostly sideways since the start of March means that the prices of equities and government bonds have been largely uncorrelated lately. This contrasts with the first two months of the year, when a sharp surge in long-term rates resulted in a steep drop in US Treasury prices, while stock markets continued to climb. The resulting countermovement of the two major asset classes created good diversification opportunities for multi-asset class investors, notably reducing overall portfolio risk.
The chart below shows the contributions from major risk-factor types and their pairwise interactions to overall portfolio volatility at the beginning of February, compared with a more recent breakdown as of April 23. The red dots indicate the overall predicted risk of 7.2% and 6.6%, respectively. Even though the total risk numbers are not very different, the respective decompositions are. In February, equities—which make up half of the portfolio’s market value—accounted for pretty much the entire predicted return variance. Meanwhile, other contributors—such as fluctuations in FX and interest rates, as well as the co-movement of equity and credit-spread returns—were neutralized by the inverse interaction of stock and sovereign-bond prices, combined with offsetting exchange-rate movements.
Portfolio volatility contributions from major risk-factor types and pairwise interactions
The picture was very different on April 23, however. Equities remained the predominant source of risk, but only accounted for a bit more than half of the total expected volatility. The renewed co-movement of share prices and exchange rates against the USD—as the dollar resumed its downward trend—added to overall risk this time. The previously risk-lowering effect of the stock-bond interaction (depicted in dark blue), meanwhile, disappeared, as the correlation between the two (also highlighted in the same color in the matrices below) dropped to zero. The contribution from the earlier co-movement of equity and credit returns also all but disappeared, as their correlation was squeezed from 0.81 to 0.31 (marked in grey).
Major risk-type correlations
The considerable changes in risk-factor correlations were also reflected in how the different asset classes in the portfolio contributed to its total volatility. The inverse interaction of equity and sovereign-bond returns in February meant that almost all fixed-income securities in the portfolio actively reduced overall risk. The only exception were high-yield bonds, where the more pronounced credit-spread fluctuations counterbalanced any movements in risk-free interest rates.
Portfolio volatility contributions and market-value weights by asset class
The breakdown looked very different on April 23. All debt securities now added to overall risk, thanks to a simultaneous rise of stock and bond prices in mid-April. The effect was even more pronounced for non-USD issues, whose returns were amplified by concurrent exchange-rate appreciations. This time, high-yield bonds were the category with the lowest risk contribution in relation to their monetary weight, as credit spreads had largely decoupled from share prices.
The sharp surge in Treasury yields at the start of the year was triggered by concerns over rising inflation expectations, especially once breakeven rates in the US surpassed the Federal Reserve’s 2% target in early January. To reassure market participants, central banks around the globe—the Fed in particular—have since gone to great lengths to emphasize that they are not at all concerned about this (temporary) overshooting of consumer-price growth, which helped steady long-term yields for the time being. Increased demand for high-quality government debt, due to geopolitical concerns around a new surge in COVID infections (especially in India), the slow vaccine rollout in the European Union, and sanctions against Russia also prevented yields from climbing further, despite a continued rise in share prices and inflation rates (both realized and expected).
In conclusion, we believe that stock and bond prices could remain uncoupled for a while yet. In the meantime, we will continue to monitor the situation and provide regular updates on cross-asset correlations in our weekly Multi-Asset Class Risk Monitor Highlights.
