Experts are questioning the long-trusted practice of using fixed income investments to hedge equity risk. Some fund managers argue the negative correlation between government bonds and equities has been due to unique historical conditions that may soon pass.
Peter Farac, portfolio manager at ASX-listed Pendal Group, told the Investment Magazine Fixed Income and Credit Forum, held on July 24-25 in Victoria, that his company is exploring options outside of government bonds to keep its portfolios defensive, including downside equity, put options and volatility strategies that can be switched on at appropriate times.
“There’s no law that says when equities fall bonds go up and yields fall,” Farac said.
Government bonds have been a reliable hedge against equity risk over the last 20 years or so, providing positive returns when there have been significant shocks causing drawdowns on equities, he said. But this may have been a factor of unique historical circumstances. Recent decades have seen a secular bond bull market, Farac argued, and he put this down to a number of big macro trends.
Inflation peaked in the early 1980s, and since then it has fallen, along with real GDP growth. This has been a bond-bullish force, he said.
Demographic trends such as women entering the workforce and credit growth through the 1990s have driven consumption, increased growth and helped companies and economies, driving equities upwards.
A trend of globalisation has opened up the worldwide labour pool and arguably dropped inflation. Central banks have adopted policies that have targeted inflation, meaning rates get cut every time growth falls – again a bond bullish force.
“So the market was taught over a period of time that if there is a wobble in the equity market, if there is a wobble in the underlying economies, then you will see bonds rally on the back of that,” Farac said.
Pendal Group is questioning whether this correlation will continue. US President Donald Trump is one player in a broader drive towards nationalism and isolationism in many countries, Farac said, and this reversal of globalisation could hurt equities and call into question the negative correlation between bonds and equities.
The European Central Bank is tightening monetary policy when inflation is low, departing from the expectation that low inflation means central banks will keep money easy, he said. And at the extreme end, central bank independence is being questioned, particularly in Turkey, South Africa and some other emerging markets.
“That’s going to drive a massively different outcome on how government bonds react and interest rates react in different situations,” Farac said.
But James Blair, investment director of fixed income at US financial services giant Capital Group, argued the broad credibility of central bank policy is “not being upended any time soon”. He argued a core government bond allocation will remain supportive during equity market weakness “at least for the medium term”.
He pointed to a study conducted by his company’s fixed income and quantitative analysis teams that looked at economic data going back to 1962 in eight markets, including Australia.
The study found times when the correlation between bonds and equities became positive, particularly when central bank credibility was on the line.
“Bonds were not equity diversifiers, [and] are not probably equity diversifiers in periods of high or rising inflation,” Blair said. “The data suggests around 4+ per cent inflation before – in the US anyway – you saw that correlation switch.”
