A few weeks ago I wrote about the potential situation where presumably uncorrelated or low correlated investments can move in a broadly similar direction during market downturns, causing increased downside risks for diversified portfolios.
The long-held notion, and one of the main pillars in portfolio management theory, that investment grade bonds have a low correlation to equities and that these asset classes improve the expected risk-return trade-off when combined in a portfolio, is being stress-tested by the market as investors start to realise that their portfolio of mixed investments may not be providing the level of resilience they thought it would.
With the intensification of the global equity market sell-off that resumed in the second week of November, bond markets seem to be offering limited comfort in terms of protecting the adverse impact on the portfolio.
The accompanying chart compares the average weekly returns of various euro and US dollar bond market indices provided by Bloomberg Barclays when the European (Euro Stoxx 600) or the US (S&P 500) stock market was up or down in any given week so far in 2018. The figure shows that when the stock market was up, the average weekly returns of bonds were mixed. On the other hand, when the stock market was down, the average weekly bond returns were also negative across all bond classes.
Although high yield (HY) bonds tend to move in a similar direction as equities, it is interesting to see that investment grade (IG) bonds, as well as sovereign bonds to an extent, have moved lower on average when the equity market was down.
While we have not yet seen a complete detachment in the relationship of these two asset classes, there are plausible reasons why investors are becoming less confident on the outlook of bond markets. As a result, most bond segments have seen very limited buying support with the increased market volatility and the sell-off in equities, with the exception of US treasuries and other highly rated sovereign bonds on particular occasions.
Slowing economic growth, geopolitical tensions and concerns on global trade have reversed the strong global growth outlook anticipated at the beginning of the year
Slowing economic growth and geopolitical tensions, including rising concerns on global trade, have reversed the strong global growth outlook that markets anticipated at the beginning of the year.
These developments, together with the reassessment of the previously high corporate earnings growth expectations, seem to be driving the increased market volatility pushing equity markets in a severe market correction.
On the monetary front, central bankers have continued to point towards a tightening environment by halting quantitative easing programmes and guiding towards a rising interest rate environment. This persistent forward guidance is capping the upside potential of bond markets.
Moreover, the increased level of corporate debt, namely in the US, as companies took advantage of the low yield environment to increase their borrowings, is increasing fears of credit weakness and probability of defaults within the corporate bond space. We are slowly shifting away from the benign environment and the elevated market complacency that generated positive returns momentum across practically all markets since the recovery from the recent financial crisis.
The combination of these factors is creating an ambiguous market regime which poses great challenges for investors to stir through.
The ability to manoeuvre portfolios effectively and swiftly is becoming once again an essential requirement for multi-asset portfolio managers, but which, at the same time, increases the likelihood or the risk of failure.
Alternatively, investors and portfolio managers are seeking alternative asset classes, or non-traditional asset classes, to complement their investment holdings by searching for opportunities that are less influenced by the market forces outlined above. On the global landscape we are seeing greater participation in infrastructure or real estate investment vehicles as well as direct lending or private lending and structured products. Within the local market, we are also seeing more participation and greater scope for increasing exposure in selected corporate bond issues as well as carefully filtered bond and equity issues of small and medium enterprises listed on the Prospects MTF.
These investment venues have different risk-return characteristics as well as liquidity considerations to be taken into account. Moreover, the opportunity set found in these segments may not be large or liquid enough to build and manage a substantial allocation of the investment strategy. However, such instruments may prove to be return enhancers as well as risk diversifiers, thereby increasing the resilience of the portfolio, through a limited exposure within an investment strategy.
Matthias Busuttil is senior portfolio and investment manager at Curmi and Partners Ltd.
www.curmiandpartners.com
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.