It has been a tough year for balanced portfolios.
Equities and bonds have suffered from an increasingly aggressive monetary policy pivot from “low and loose” to “high and tight”. This hawkish pivot by global central banks has come in response to high and persistent inflationary pressures in the post-pandemic recovery.
Since the start of the year, the yield on the 10-year Treasury has doubled, from 1.5% to 3.0%. Bond prices have struggled to hold value in the face of aggressive rate hikes and rampant inflation. Furthermore, the war in Ukraine and China’s zero-COVID policies have added to inflationary pressures and triggered economic growth concerns.
As of this writing, the US aggregate bond index is down -10% YTD and the S&P 500 is down -14% YTD.
Methods for the Madness: Diversifying Portfolios when Correlations are High
What we have seen this year is a relatively rare occurrence. Stocks and bonds typically have different risks. As a result, owning a mix of stocks and bonds generally helps protect portfolio values against large downturns. Unfortunately, both stocks and bonds have meaningfully decreased in value this year. In portfolio-geek language, the correlation between stocks and bonds has been high. In today’s environment, the traditional diversification that helps protect portfolios has remained elusive.
So, what can investors do to reduce the risks of high correlations?
The first step is to ensure diversification within asset-classes. In equities, it means owning stocks across sectors, regions, and styles. In fixed income, it means owning bonds across varying maturities, credit quality, and market segments.
The second step is to consider allocating to real assets in portfolios. At Accuvest Global Advisors, we hold a basket of diversified commodities for most client portfolios. We believe commodities offer attractive value and cost-efficient protection against inflation. Importantly, commodity prices are subject to risks that are different from the economic growth and interest rate risks behind stock and bond prices. Commodities are a key source of diversification in a market environment where high inflationary pressures are weighing on both economic growth and interest rates simultaneously.
The chart below shows rolling correlations over the past 5 years between the S&P 500 and the US corporate bond index, and between the S&P 500 and the GSCI commodities index. When correlations are high, the assets are moving in the same direction. When correlations are low, the assets are moving in opposite directions. Assets with lower correlations provide those diversification benefits we discussed earlier. Looking at the data, we see that bonds have tended to exhibit negative correlations with stocks, while commodities have exhibited positive correlations. However, as we have entered 2022 these relationships have been turned on their heads. Bond correlations have turned positive while commodities correlations have turned negative.
An allocation to commodities provides welcome diversification to balanced portfolios. Although it does not guarantee against loss, diversification is one of the most important tools for reaching long-term financial goals and insuring against ruinous outcomes.
Commodities as an effective inflation hedge
Commodities give portfolios the opportunity to produce returns that are not reliant on economic/earnings growth (equities) or interest rates (bonds). Accordingly, commodities bring a third source of returns to portfolios by offering competitive real return potential if inflation stays high and persistent.
Since the 1980s, inflation has remained low and well-anchored. As a result, traditional balanced portfolios outperformed commodities, with tailwinds from falling inflation risk premia and the search for yield. But as we are seeing in 2022, balanced stock-bond portfolios can struggle when high inflation pushes interest rates higher and real economic growth lower.
Equities provide a claim on nominal growth and can be an inflation hedge if companies have pricing power and/or stable input costs. But as we have seen, inflation has triggered central bank tightening and it is weighing on equities, especially leveraged or expensive stocks. Similarly, inflation has eroded real returns in fixed income and rising yields have caused bond prices to plummet. In contrast, commodities appear inexpensive given their supply and demand imbalance and intrinsic exposure to inflation. These characteristics provide effective portfolio protection.
We believe traditional portfolios remain under-invested in commodities and real assets. We view this alternative asset class a vital risk diversifier for clients. More so, barring a synchronous and significant negative global demand shock, we believe commodities have the potential to continue outperforming the traditional asset classes.
Investor optimism has faced increasing pressure during Q1 of 2022. Advisors and asset allocators are tasked with navigating high inflation, slowing economic growth, rising interest rates, and most recently, an escalating geo-political conflict. As the fog of war creeps in, we recommend a disciplined data-driven approach to asset allocation and portfolio construction.
We believe the key question facing investors today is: Are we entering a prolonged period of economic contraction and negative earnings growth? If the answer is yes, then downside risk remains for equity and commodity prices (and fixed income, now offering higher yields, would screen as attractive). If the answer is no, and the global economy does not enter a recession, then there are investment and rotation opportunities to capture.
The preponderance of our data suggests that the recent market sell-off has “priced-in” more than just uncertainty and indigestion surrounding the acceleration of monetary policy tightening (more rate hikes sooner). We believe escalation and extrapolation of risks surrounding Russia has forced the market to begin “pricing-in” an oncoming recession. Our indicators continue to suggest low unemployment, high corporate investment, and resilient household consumption. We expect a peak in inflation and no economic recession during the next 12 months.
If our assessment of the economy and inflation proves accurate, and the FED stays flexible and “data dependent” with rate hikes, then many investors have over-priced the fundamental risks facing markets today. As an example, bearishness, as surveyed by the American Association of Individual Investors, has averaged 47% over the last 4 weeks (as of March 17th). This level of bearishness is rare, standing 17% above average and experienced only 4% of weeks since 1988.
Understandably, transitioning from loose monetary policy to tight monetary policy is never “comfortable” for investors. However, history shows us that the 24 months after the beginning of a rate hiking cycle are rewarding for investors (using data since 1970). Rate hiking cycles begin when the economy is strong enough to generate inflation (demand outpaces supply) and unemployment is low. This is the state of the economy today, and we expect corporations and consumers to show resilience once again to the ratcheting up of interest rates and the cost of credit.
We continue to see evidence for maintaining economic optimism and underweighting fixed income in portfolios. Interest rates are normalizing for good reasons – high inflation, robust economic growth, and still low real yields. Within fixed income portfolios, we prefer short duration credit (floating rate loans where possible) and inflation protected treasuries.
We allocate the proceeds from being underweight fixed income to commodities. Commodities offer effective and efficient inflation protection for portfolios while also hedging prevalent geo-political risks. Within commodities energy is a key exposure that looks more attractive near-term than medium-term. We complement energy with allocations to metals (base and precious) and agriculture – both of which exhibit more impressive medium-term supply and demand imbalances than oil.
In equities, we see less risk in US value and quality factors. As investor confidence returns, and geo-political uncertainty abates, we expect to increase portfolio exposure to undervalued international equities more leveraged to economic growth and higher interest rates (cyclicals, financials, and commodity exporters).
Opportunities and upside remain in the equity and commodity asset classes, but the texture of returns and leadership within those asset classes is expected to differ from the last 10 years. Please let do not hesitate to contact marketing@accuvest.com if you would like to explore and discuss our real-time asset class preferences, portfolio positioning, or economic outlook.
Disclosures: This information was produced by and the opinions expressed are those of Accuvest as of the date of writing and are subject to change. Any research is based on Accuvest proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however Accuvest does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. Any sectors or allocations referenced may or may not be represented in portfolios of clients of Accuvest, and do not represent all of the securities purchased, sold or recommended for client accounts.
The reader should not assume that any investments in sectors and markets identified or described were or will be profitable. Investing entails risks, including possible loss of principal. The use of tools cannot guarantee performance. The charts depicted within this presentation are for illustrative purposes only and are not indicative of future performance. Past performance is no guarantee of future results. Actual results may vary based on an investor’s investment objectives and portfolio holdings. Investors may need to seek guidance from their legal and/or tax advisor before investing. The information provided may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved and may be significantly different than that shown here. The information presented, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.