But, recently that negative correlation between bonds and equities has become less reliable. Dan Kemp, head of investment consulting and portfolio management EMEA at Morningstar, explains that from looking at the five-year rolling correlation data between UK equities and gilts, for the past 30 years the correlation has generally been negative or neutral in falling markets.
“This means that when equities fell, gilts offset some or all of that fall,” he says, adding, “the trend has been especially strong over the past decade.”
But, he points out, judging from where yields are currently, after 30 years we are very likely closer to the end than the beginning of the bond bull market.
This has been predicted by many over the past few years, including Bill Gross, manager of the world’s largest bond fund, who called the end of the bull market as far back as the beginning of May last year.
Bonds have continued their run, however, buoyed as they have been for a number of years by benign inflation and the policies of money printing by the central banks of Japan, England and the US. But with the Fed now slowing the rate of quantitative easing and the Bank of England beginning to talk about a turn in the interest rate policy as the economic recovery in the UK picks up pace, the longevity of that bull run is being even more stringently questioned.
Regime change
If it is indeed the case that bonds can no longer be relied on for downside protection, portfolio construction, especially at the lower risk part of the spectrum, becomes a lot trickier.
“This could be the trend that dominates portfolio construction for our careers,” adds Kemp. “When you are facing a regime change such as the end of a 30-year bull run, it is likely to continue for a long time.”
Gavin Haynes, managing director at Whitechurch Securities, agrees that after such a prolonged bull market, if government bonds are looking structurally overvalued, portfolio construction becomes more complex.
One of the problems facing asset allocators in the short term is that most asset classes are looking stretched, especially in the fixed income market.
Nigel Marsh, manager of European Wealth’s fixed income mandates, says much of this complexity stems from the central bank actions that have thrown all the risk parameters out. “Increasingly one needs to separate out government bonds from credit bonds,” he says.
On the government bond side, he says no-one has really taken on board the various central bank actions to push up inflation: “They are still buying government bonds left, right and centre because they are perceived to be anti-risk, but experience of the periphery markets has proved they are not.”
On the other side, in the credit market, he adds: “You have the Fed warning credit bond holders about spread risk, equity markets are handsomely off the top and still credit spreads are at their narrowest.” In the government bond space, he says yields have risen substantially: “If you look at two-year gilt yields, when Mark Carney came to power last August they were close to 30bps, now they are closer to 100bps; that allows a lot more for the interest rate rise that we are going to see at some stage and makes them relatively good value. But, if you look for example at Tesco, its 10-year bond yields is just over three, while the dividend is just over five.
Adjust expectations
Richard Stammers, investment strategist at European Wealth takes the point even further: “Historically, we have built the way we approach our portfolios on the fundamental principle that sovereign debt generally speaking has been a lower-volatility asset relative to domestic equity markets.
“Putting volatility to one side, it is that inbuilt capital loss that is the problem. It is a significant risk that people are going to have to face and that is before we even start looking at capital markets.” For Stammers, the primary danger is that clients have not yet adjusted their risk and yield expectations.
“They think I am going to move up the risk scale, and that there are people advising clients to do just that and the chances are they are going to get burned. People need to stay true to what their needs are, if they are lower risk, stay lower risk, even if it means lower returns.”
A smaller role to play
For Ed Smith, global strategist and co-head of REMAP, Canaccord Genuity Wealth Management, the key to finding superior, risk-adjusted returns over the next few years is going to be finding alternative diversifiers.
While he has not written off the diversification properties of bonds entirely, Smith believes that they will have a smaller role to play He explains: “You can rely on them to [be negatively correlated to equities] when equities sell off because of growth concerns. So they still have a place but it is a much reduced place because there will be equity market sell-offs that are driven by an unexpected tightening of monetary policy or an unexpected rise of inflation and, in those examples, equities and bonds will sell off at the same time.”
Justin Onuekwusi, lead portfolio manager of LGIM’s multi-asset funds, agrees that in the short term the relationship between bonds and equities is likely to be elevated, especially as and when the Fed and the Bank of England begin to raise rates. He also agrees that in the case of a growth shock, bonds are likely to continue to prove a good diversifier. But, he adds: “It is important to recognise the weakness of correlation as a measure. It is important to look at slices of history, rather than the average correlation number.”
What’s the alternative?
That said, most commentators have been looking at alternative asset classes that, ideally have a low correlation to both equities and bonds, and also generate a positive return regardless of the overall direction of growth assets. The three most popular examples of such are infrastructure, absolute return funds and commercial property, but they are all not without their challenges.
According to Smith, the structural case for infrastructure is built around the significant misallocation of capital that has taken place over the past 10 years, particularly in the UK and Europe.
However, he is quick to caution that, from a UK investor perspective, many of the vehicles through which one might access this market, for example infrastructure trusts, are now trading at quite large premiums and so they are not as attractive as they once were. “If you already own them it is probably worth hanging on to them but as an entry point today it is probably less attractive,” he says.
Stammers says for many the obvious choice of diversifier is commercial property, but the increased interest in the asset class has driven yields to ridiculous levels, especially in London.
He says: “There are opportunities outside in more regional areas, and there are funds being launched, such as the Kames Property Income portfolio, which is specifically targeting more regional centres but, here too, the inflows are huge.”
For Matthew Butcher, investment director at Dart Capital, absolute return funds might well return to favour as a potential replacement for a very high level of fixed income in low-risk portfolios, but he says: “They have produced a lot of noise for very little return in recent years, something that could have left some people a little disillusioned with the sector.”
Cash is king
The other asset class that could see its role grow is cash, he says, explaining that traditionally high cash holdings have been seen as indicative of a lack of investment activity. But, he says, going forward cash is going to have to play a greater tactical role.
“Tactical cash allocations are likely to rise, both for efficient portfolio management and downside protection and even strategically, for some period of time, high levels of cash in portfolios may be something we see a lot more of,” he adds.
“We are already seeing a lot more of it in some multi-manager funds and that may well lead some progressive wealth management firms to think a little more in depth about their core allocations.
But, he adds: “It is a brave call to make and a difficult conversation to have with clients. But, in the current environment capital preservation is important.”
This is certainly the case for Onuekwusi, who says he is currently shortening the duration in his portfolios, and selling risk assets as and when they strengthen.
He says: “We are moving into an era of rate hikes and we are really concerned about the first communication from central banks in this regard. If it is not what the market expects there will be no hiding place; cash will be the only protection.”
It is, of course, impossible to know how things will play out, but it is clear there are significant changes taking place. And, as with any regime change, whether or not one backs the winning faction will decide if you are showered with wealth or thrown out with the old guard, which is a pretty high-risk game, and could be why fealty to an even older king, cash, is rising.
