After a difficult 2022 when portfolio risk climbed to the highest level since the COVID-19 pandemic, a basic tenet of risk management – the decorrelation between equities and bonds – has returned this year.
This was a topic discussed during a panel on macro trends on May 25 in Singapore organized by Enfusion. The software-as-a-service company is a leading provider of cloud-native solutions for investment managers, and since April this year, Qontigo’s Axioma Risk capabilities have been available on the Enfusion platform.
We sat down with Olivier d’Assier, Head of Applied Research for APAC at Qontigo, to delve deeper into his comments at the event and find out more about this ‘return to normal’ for financial markets. Below is our exchange.
Olivier, you made the point during the panel that stocks and bonds became positively correlated for a while in 2022 and are negatively correlated once again — as they have been traditionally. What caused this correlation to flip in 2022, and what did it mean from a portfolio risk-management perspective?
“Multi-asset portfolio managers can usually rely on certain ‘known’ pairwise correlations across risk types to harvest diversification benefits and achieve an overall portfolio risk that is less than the sum of its parts. For example, the long-term correlation between equities and interest-rate risk is around -0.32, which gives 60-40 types of portfolios a good diversification potential, most of the time.
“However, at times, these correlations can suddenly change and become very disruptive to portfolios managers. This was the case between June 10, 2022, and March 10, 2023. During that time, the unprecedented rapid rise in interest rates by the Fed to fight decades-high inflation led investors to sell both equities and sovereign bonds – both of which are very sensitive to changes in monetary policy. As a result, the correlation between equity and sovereign bonds became strongly positive during that period, and, instead of decreasing portfolio risk, contributed positively to portfolio risk.” (Figures 1 and 2).
Figure 1 – Portfolio risk contributions from pairwise risk-type correlations
“In Figure 1, the bars show the sum of the weighted pairwise cross-asset class correlations, and the red line displays the total portfolio diversification (right vertical axis — the lower the line, the more diversification is reducing portfolio risk). Around Nov. 18 last year, the sum of cross-asset class correlations jumped to 5.53, reducing total portfolio diversification to just -3.16% (i.e., the cross-asset class diversification benefit for the portfolio reduced total portfolio risk by only 3.16% that week). On May 19 this year, however, the sum of cross-asset class correlations was actually negative (-1.17) due to the negative correlation between equity and sovereign bonds, issuer credit and sovereign bonds, as well as between equities and FX.”
Figure 2 – Correlation between US equities and US Treasuries, and international government bonds
Can you give us an idea of how portfolio risk increased during the tumultuous summer of last year?
“Portfolio risk rose from 12.5% on June 10, 2022, to 22.5% the following week, and averaged around 15% during the period when equity and interest rates were positively correlated (Figure 3).
“The outsized impact that this change in correlation had on total portfolio risk comes from the fact that equities are 50% of the portfolio and sovereign bonds another 15%. Not only did these two risk types suddenly become positively correlated, but their individual volatility also rose sharply (both saw their standalone volatility double during that period). So, higher volatility plus positive correlation equals a large increase in portfolio risk (i.e., what we own the most suddenly became riskier and positively correlated, leaving us no place to hide).
“During that period, the total portfolio diversification fell from shaving a total of 7.7% in total uncorrelated portfolio risk to shaving only 2.1%.”
Figure 3 – Portfolio risk by risk type
So what can a portfolio risk manager do in that situation?
“Given that most portfolio managers have a risk mandate, and that diversification was no longer available to reduce portfolio risk, this left them with only two solutions: buy portfolio insurance, or sell some of the risky assets (i.e., equities), which is what they did to quickly reduce portfolio risk to within mandate constraints. In fact, investors sold off both equities and sovereign bonds and both asset classes ended up having one of their worst years in decades.”
And what’s driven stocks and bonds to decorrelate once again this year?
“The banking crisis in early March 2023 sent investors out of risky assets and into safe ones, like US Treasuries. This reverted the positive correlation between equity and interest rate risk back to negative on March 10, 2023. It has remained negative since then as worries about a possible US default have kept investors in a risk-averse mood. As a result, our portfolio risk has dropped to just 5% as of May 19, 2023, close to its long-term average (since December 2016).”
Portfolio risk and market volatility have come down considerably this year, yet there are enough reasons why investors could continue to worry. What does this tell us about current investor sentiment?
“Uncertainty remains elevated as the timing of an eventual soft-landing and monetary pivot by central banks keeps getting pushed back. Investors had originally hoped for a monetary pivot this year, but it now looks increasingly likely that this will not happen, if at all, until next year. Until then, investors are likely to stay in the more risk-averse segments of the market, preferring recession-proof companies to cyclical ones.”