Quantitative strategy

After the storm comes great expectations

10 October 2022

Nikola Vasiljevic, Head of Quantitative Strategy, Zurich Switzerland; Lukas Gehrig, Quantitative Strategist, Zurich Switzerland

Key points

  • 60/40 portfolio investors have had a tough year, as US equities and bonds fall in tandem for the first time in 50 years
  • Soaring inflation and aggressive rate hikes to counter it have hit financial markets hard this year. The central bank “put”, to insure against asset price falls, is nowhere to be seen, and equity and bond volatility has doubled this year
  • From a cross-asset perspective, the expected credit premium has increased over the last twelve months, while the expected term and equity premia have compressed
  • As ever, holding firm through periods of high market volatility and sticking to your plan usually works. While bonds may have lost their portfolio diversify appeal for now, longer-term bond and equity returns still look healthy

A typical 60/40 portfolio, or 60% allocated to equities and 40% to bonds, has been severely punished this year. Equity and bond markets have fallen in lockstep, and are vulnerable to macro uncertainty and political risks. However, the long-term outlook looks better, and expected returns have significantly increased over the past twelve months.

The pandemic-induced global health and supply-chain crises, and supply-demand energy imbalance, hurt the economy. Recent geopolitical events have only rubbed salt into the wound by unleashing global energy and food price shocks, and likely ushering in a more fragmented, precarious world.

When diversification benefits erode 

Government bonds are widely regarded as a safe-haven investment. Historically, they have been lowly correlated with equities and, perhaps more importantly, provided protection during bouts of equity market turmoil.

The correlation between equities and bonds has varied substantially in the past. Macro regimes and uncertainty are among the main drivers of these dynamics. Nevertheless, the simultaneous fall in US equity and government bond returns this year is unheard of over the past 50 years, until now.

This year marks the first time US equities and bonds returns have fallen together since 1973 (see chart). Admittedly, the year is not over yet. Unless there is a strong rally in equities and bonds – which seems unlikely – it seems that 2022 will go down in history as the first outlier of this kind.


Stocks and bonds moving in a lockstep

By zooming in on 2022, you can see how much equities and bonds have moved in sync, and downwards. US equities and government bonds are off by -23% and -11% respectively so far this year1.

An American 60/40 portfolio has seen a drawdown of about 19%. Focusing on the last two decades, such losses by the end of September have only been seen during the bursting of the dot-com bubble in 2002 and at the peak of the global financial crisis in 2008. In fact, a typical US 60/40 portfolio has had the worst start to the year this century.

Although comparable in terms of drawdowns, the crucial difference to this year is that government bonds fulfilled their portfolio diversifier and equity tail-risk hedging roles back in 2002 and 2008 (see chart). As mentioned above, this has not been the case in the post-pandemic world, as the US equity-bond correlation (measured on a three-month rolling basis) is highly positive. 


Inflation: Pandora’s box

Inflation has sped to multi-decade highs this year. Pent-up demand, accumulated during the pandemic, coupled with supply-chain bottlenecks, rising wages, and soaring oil, gas, and electricity prices have paved the way for a new, more volatile macro regime.

Accommodative monetary policy helped government bonds to offset some equity drawdowns in 2002 and 2008. In contrast, soaring inflation and aggressive, synchronised interest rate hikes (see chart), when economic activity was already slowing, have scared almost all financial assets this year, particularly long-duration assets. Relative to their respective historical averages, equity and bond volatility has doubled this year. 


It’s darkest before the dawn

The macro landscape suggests that bonds have lost their appeal as portfolio diversifiers. Should inflation and economic uncertainty persist over the next three months, a 60/40 portfolio might sustain further losses this year. The portfolio’s diversification benefits have slowly eroded over the last decade, culminating in the breakdown of uncorrelated equity and bond returns in 2022.

However, if we look beyond short-term market gyrations and volatility, there are reasons for optimism as the long-term outlook has improved recently.

Currently, market-implied expected returns over the next ten years are on average 2-3% higher than twelve months ago. This holds for both equities and fixed income assets and follows interest rate normalisation and repricing in equity markets.

Shifting tides of cross-asset risk premia   

Since expected long-term nominal returns have been lifted across the board this year, it is worth examining the attractiveness of different asset classes on a relative basis. The expected term and equity premia have actually decreased, according to our analysis, whereas the expected credit premia for investment grade (IG) and high yield (HY) bonds have increased lately.

The expected term premium – defined as the difference between the US Treasury 10-year yield and the current cash rate – has slid about 70 basis points (bp) since September 2021. If we consider the expected cash rate over the next ten years as the proxy for the risk-free rate, then the expected change in the term premium would be around zero.

The expected equity and credit premia are calculated as the difference between the expected returns for the respective asset class (US equities, investment grade and high yield bonds) and the US Treasury 10-year yield.

Our findings indicate that the expected equity risk premium has decreased by 120bp, whereas the expected IG and HY credit premia have increased by 50bp and 100bp respectively (see chart). 


Asset allocation implications: reasons to be hopeful

Higher interest rates signal a positive impact on fixed-income assets in a portfolio. They are expected to provide a better source of income, while also leaving room for capital gains if rates reverse at some point in the future. Arguably, locking in rates at current levels seems plausible from a long-term investment perspective.

Under the cross-asset microscope, credit seems more attractive than last year. However, uncertainty will likely remain elevated in the next few months, which could push spreads up. Therefore, it is very important to remain cautious and selective, especially with high yield and emerging market bonds. 

Long-term expected returns for equities have also increased this year, although they appear less attractive on the relative basis. However, since further multiple compression is on the cards amid macro and geopolitical uncertainty, it is possible that the equity risk premium will recover soon. For investors seeking exposure to “bond-like” equities, quality and dividend investment styles could be an interesting sub-asset class.

Last, but not least, many investors are hungry for sources of uncorrelated returns. Given today’s macro conditions, market-neutral hedge funds appeal as a way to improve portfolio diversifications.

The shift in expected risk premia is less problematic for a diversified portfolio which harvests different return sources and factor exposures. This allows investors to focus on the long run. Staying invested, being well diversified, and sticking to your plan are some of the key pillars of successful investment strategies.

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