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It is fair to state that financial conditions will tighten over 2022. As of tomorrow, till mid-June 2022, the FED will purchase a total of USD 280 billion in US Treasuries and USD 140 billion in agency Mortgage-Backed Securities, actively adding USD 420 billion of liquidity to the financial system. After March 2022, the intensity of ECB intervention will also slow down, but it will require the December 16 meeting to measure the impact. Nervousness in financial markets is rising. That becomes visible across liquidity and volatility measures on each side of the Atlantic. Implied volatility in US rates, as measured by the MOVE (Merrill Lynch Option Volatility Estimate) index, is about to break out above 80. That level used to be the upper bound over the past 5 years. In US equities, the VIX index never succeeded to break below the 15-handle since the pandemic erupted. Between 2016 and early 2020, the VIX fluctuated between 10 and 15 and was testament of the presence of a FED put. The FED always acknowledged the cry by markets the moments financial conditions tightened with a sudden reversal of taper policy on the side of the balance sheet or sudden rate accommodation. The intermediate phase for accommodation leapt into crisis management as of March 2020. Today, the risk management approach adopted by DM central banks in the face of unanchoring inflation expectations is straightforward. They will not budge in their resolve to lessen monetary accommodation. On the back of excessive inflation and continued employment recovery Jay Powell nor Lael Brainard will come to the rescue of markets. In that sense, public financial markets have adopted a peculiar behaviour. A behaviour that favours market sectors that boast the highest valuations. How long such targeted risk-seeking attitude (or neglect of risk aversion) can endure is impossible to gauge. What is possible though, is to prepare portfolios for an episode of increased volatility. Currently, with liquidity and volatility measures not flashing red, it makes sense to study your diversification quality.
Proper portfolio diversification, and acceptable portfolio volatility, is reached by combining asset classes that exhibit low correlations. Investors seek negative correlation so that, when one asset class corrects to the downside, other asset classes move up and cushion the mark-to-market blow. However, correlations are not static through time. Bond-equity correlations have been deeply negative since 1998 till 2020. These 20 years have been characterised by, on balance, accommodative monetary policy next to a stable disinflationary economic background. Disinflation was a result of unrelentless globalisation zeal. An erratic president and a tragic pandemic have halted globalisation-as-was. Supply chain disruption might explain about 75% of the (cost-push) inflation surge over the past 6 months. 25% is caused by pent-up demand (demand-pull inflation) as the boost of disposable income has been formidable in the US. Less so in continental Europe explaining the lower inflation pulse. Bond-equity correlation has been moving towards zero and we are confronted more often with positive correlation mini-shocks. Mini shocks that are still measured in hours or days. The buy-the-dip mentality is well engrained across retail and institutional investors. As if both reinforce each other.
Now, we are all aware that correlations increase during periods of stress. Most often, bond-equity correlations became less negative! Meaning that capital protection ability were still intact and acceptable. The starting point matters. Today the starting point is less reassuring as it sits at zero or in positive territory. In the US, we notice that positive bond-equity correlation conditions are in the making. US inflation ticks the box. However, US monetary policy must flip firmly into tightening modus. The latter is clearly not the case yet. The FED is less accommodative. In Europe, the inflation estimates for 2023 drop well below 2.00% again (European Commission estimates issued this week). Even under conditions that sees the inflation surge as temporary the message remains the same and calls for proper preparation.
Reaching out to traditional asset allocation models might be too simplistic against the challenges ahead. Over the past decade, I have learned to focus on risk factor exposures. Risk factors are the underlying risk exposures that steer the return of an asset class, from government bonds, credit over equity. Within fixed income, we can isolate rate risk factor exposure (sensitivity to changes in rates), credit spread risk factors (systematic or broad market-based as well as company specific elements) and FX risk factors. Imputing correct loadings for each of these factors in a diversified bond component will provide you with a better sense of portfolio robustness. The variance of returns attributed to each of those factors across the holdings in a portfolio are monitored and saved. The correlation (covariance) matrix between the historical returns contributed by each risk factor is built. At that moment, you can construct a portfolio that has exposure to a maximum amount of independent risk factors. Your creativity is the only boundary to the number of risk factors you can track. In fixed income, seeking exposure to the inflation factor has been highly profitable. Have a look where pure inflation linked global bond funds ended the past week…near +7.00% year-to-date. Exposure to the EM rates factor has not been easy to hold onto in a balanced portfolio over the past couple of years. Current portfolio optimization runs, however, allocate highly to the EM sector as the carry factor versus the credit risk factor becomes attractive. EM risk factor loadings increase versus other bond sectors.
Within equity markets, the growth versus value factors are commonly used. Value factor exposure has been the most beaten up style between 2009 and 2019. However, exposure to value factors is staging a comeback of late. The uncertain rate outlook has moved investors into an attitude of ‘better diversify more into value today than to be very sorry tomorrow’. Momentum – invest in the stocks that have had the strongest 1-year returns, ascribing to the theory that strong returns will beget outperformance in the following period – has always been a factor that performs best in the later stages of a bull market phase. The size factor (large versus small caps) deserves more attention in favour of small caps. Low volatility, quality, dividend, high yield also belongs to the traditional equity risk factor range. With the rise in thematic investment solutions comes also the interest in factors that will earn a premium over time, such as carbon intensity, revenue exposed to green versus brown assets or overall climate risk factors. Historically, the process of finding the correct loadings across factors has been part of active investment management. Today, we see that passive investment solutions turn away from market cap-based frameworks and adhere to factor-based universe construction.
Improving the diversification quality that gets investors through bull and bear episodes is a theme that deserves attention. Especially when investors assess that the future might hold even more surprises than we were able to imagine till today. Using risks factors across a global set of bond and equity sectors requires courage, as traditional sector exposures will need to make room for other securities expressed in other currencies than solely and mainly in EUR and USD.
Constructing investment portfolios with a global reach is a must. Applying smart diversification methods becomes a key attribute for long-term success. Investors might have to revise yesterday’s traditional sector weights with tomorrow’s winning weights. Understanding risk factor exposure investment is required.