Market dynamics change over time, and past relationships that may have existed for decades or longer can change. The key to portfolio construction is understanding whether it is a short-term aberration or a more permanent change. There is no denying that in today’s market, many relationships are not functioning normally. Take gold – at a new high of $2,500/oz+ – an advance that flies in the face of high real yields (normally a negative for gold) and a generally strong U.S. dollar. Or how about the inversion of the U.S. yield curve for 23 months with no recession?
It is foolish to believe that, in a dynamic system such as the markets or economy, single-factor relationships will always work; there are simply too many moving parts that can disrupt such relationships. Gold is up here for a number of other reasons, and perhaps that recession is just delayed. Correlations, too, will likely not persist at such high levels and have perhaps started to soften. In our opinion, the cause behind many of these broken or challenged historical relationships is inflation and higher short-term interest rates.
We all suffer from recency bias, over-emphasizing recent experiences or history over longer time frames. Perhaps the 2000s and 2010s were anomalies, periods with low or negative correlations, dreamy environments for portfolio construction, and 60/40 portfolios. Interestingly, this 20+ year period enjoyed general price disinflation. In the 2000s, it was thanks to a rapid rise in global trade as manufacturing moved to lower labour-cost jurisdictions (led by China), putting downward pressure on prices. In the 2010s, the global economy, consumers, and corporations were repairing their balance sheets by deleveraging. This suppressed global economic growth and contributed to disinflation. Disinflationary pressures helped keep bond/equity correlations lower.
Fast-forward to today, and we should not be surprised to see correlations higher than in recent history. While high, correlations are actually closer to longer historical norms. The real question is, what to do about it, and what happens next?
Correlations likely to soften – Inflation is normalizing and coming down. This has central banks dialling down short-term interest rates, which should help soften correlations. And the market is becoming more concerned with the pace of economic growth, or more specifically, the pace of slowing. If you want a simple rule, a market primarily concerned with inflation, correlations will likely be high. In a market concerned with recession risk, correlations will be lower.
We have seen this over the past couple of months. Unfortunately, we will likely not enter a disinflationary world similar to the 2000s and 2010s anytime soon. A number of longer-term trends will likely keep inflation as a recurring market risk in the coming years. These include:
- The disinflationary impact of rising global trade has slowed. Tariffs, protectionism, and a gradual move to a more polarized world are inflationary.
- The Energy transition may prove disinflationary as technology advances, but today, it is not. Energy costs are higher, and this translates into higher prices.
- Wages over the past couple of years have been rising as fast or faster than inflation. Given that our economies are tilted more toward service, higher wages drive higher prices. And if you have noticed any recent labour disputes, resolutions are quick and costly.
- The cost of capital used to be much lower. Now, not so much. Part of this is due to demographics as the disinflationary force of more savers than borrowers softens. The population is also getting older and moving more towards the decumulation phase.
Countering these inflation factors are the disinflationary forces of technology and higher debt. It is never a straight line, but we would argue inflation will not go quietly into the night. This may lead to correlations remaining higher than in the previous two decades.
What to do about higher correlations – Bonds are not broken, and the 60/40 is not dead. However, bond risk mitigation contribution to portfolios will likely be lower than what we were used to in the 2000s and 2010s. The silver lining is that with yields higher than in recent history, they do now carry a more pronounced return contribution.
That being said, tweaking the traditional 60/40 to find different sources of diversification likely makes more sense today and tomorrow than in years past. Becoming more global helps a little. However, higher correlations are a global phenomenon that limits diversification gains. There are two sources of diversification we believe are worth increased consideration from a portfolio construction perspective:
Commodities – The prices of many commodities and commodity price-sensitive equities offer an added diversification benefit. Gold, oil, and broad commodity price indices all carry very low correlations to equities during periods of heightened bond/equity correlations. They also tend to do well when the U.S. dollar weakens, another positive from a portfolio construction perspective. The downside is the volatility in the commodities, and related equities are material, often much higher than bond volatility. Commodity prices often react to short-term supply/demand dynamics, which can oscillate a lot. Many are very sensitive to changes in global economic growth, such as base metals or energy. Some behave based on other factors, like gold. Commodity exposure offers a good source of diversification but should be used sparingly, given the inherent risk/volatility.
Alternatives – This very diverse asset class certainly offers unique strategies that have investment streams, unlike traditional assets, which have diversification benefits from a portfolio construction perspective. The challenge becomes which sub-strategies or managers. Due diligence should not be taken lightly because, over the years, many of these vehicles have become more market beta than one would have thought. This is likely the result of a strong performing equity over the past decade, causing many to take on more market exposure to keep up. As a result, the broad alternatives index, which is a mashup of many strategies, actually is not as great a diversifier as one might expect. This can also be seen in the up/down market capture from longer ago compared to the past few decades. The good news is more narrowly, some sub-strategies continue to be more effective diversifiers. There are truly different strategies throughout, and finding them requires more due diligence. A good initial rule of thumb: if equities are up +10% and your alt is up +10%... it may be less alt than you think.
Portfolio Construction
Within our own portfolios, we classify these two subsections of asset classes above into what we like to call “diversifiers”. Diversifiers, in our eyes, can range from commodities and enhanced income strategies to volatility management or real estate. When initially constructing our multi-asset portfolios, we did not want to limit ourselves when it came to opportunities to diversify portfolios. This flexible approach ensures we are not constrained by traditional asset classes and can better navigate different market environments to ensure more resilient portfolios.
Having a portfolio baseline is an important part of your investment process. It gives you a clear starting point to figure out if you’re underweight or overweight in certain areas, like diversifiers. When you spot these imbalances, it’s easier to adjust and make sure your choices are backed by solid reasoning. This approach helps streamline your decision-making and makes your overall portfolio management process smoother and more effective.
As stated before, the 60/40 portfolio is not dead. There is no reason for panic in the streets, but to adapt to the expectations of a more correlated world, a new portfolio baseline is not a bad idea. It is nothing fancy. It simply results in lowering your bond and equity baseline by similar amounts to adjust for the amount of diversifiers you want. Within our portfolios, we have chosen a 5% baseline weight – that way, anything over 5%, we can state that we are in an overweight position of diversifiers. This lowers our equity baseline to 57% and our Bonds and cash weight to 38%. There is no right or wrong answer when it comes to setting your baseline weights; it should be designed to what you believe is necessary for your clients.
It’s often said that “this time is different,” and while markets tend to prove that wrong over the long haul, we do believe this next cycle will be different from the last. Higher correlations between asset classes look like they’re here to stay, driven by persistent inflation, shifting global dynamics, and the effects of policy changes. This means portfolios need to adapt in ways that were not necessary during the disinflationary years of the 2000s and 2010s. While the fundamental principles of diversification and risk management remain as important as ever, building a more resilient portfolio in this environment requires a new playbook. If higher equity/bond correlations are now the norm, the efficient frontier for portfolios has been nudged to the right – for the same level of return, you should expect greater volatility than before. Building a more resilient portfolio in this environment requires rethinking your playbook. By incorporating diversifiers and adjusting your baseline, you can better navigate the higher correlations and volatility that define this new cycle, ensuring you are prepared whether this time proves to be different or not.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
— Brett Gustafson is a Portfolio Analyst at Purpose Investments
Sources: Charts are sourced to Bloomberg L.P.
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