The “free lunch” provided by 20 years of negative correlation between stocks and bonds is over, balanced portfolios will become more volatile, and there are few options for investors to engineer portfolios away from this new paradigm, according to an expert at PGIM.
Speaking in a podcast conversation with Amanda White, director of international at Conexus Financial, Noah Weisberger, managing director in the institutional advisory & solutions group at PGIM, said the “efficient frontier” of optimal portfolios will shrink, and in this new regime “there are some combinations of risk and reward that just are no longer attainable as you build a portfolio of stocks and bonds”.
Weisberger previously authored two papers that analysed the drivers behind negative and positive cycles of stock and bond correlation. With the macroeconomic environment arguably supportive of an extended period of positive stock-bond correlation, a newly released third paper looked at how investors should adjust their portfolios in response.
The answer is that optimal portfolios in a positive correlation world will not be very different from optimal allocaitons in a negative correlation world, Weisberger admitted he was surprised by this finding.
Critically, he added, performance of balanced portfolios will be worse on several metrics, and investors will be “stuck with the facts on the ground.”
“Within the narrow context of a balanced portfolio of stocks and bonds,” Weisberger continued, “there’s not a whole lot you can do to mitigate that performance deficit.”
In response to this new investing environment, risk-averse investors may respond by slightly reducing their exposure to stocks. However, perhaps counterintuitively, investors that are less risk-averse may decide to lean more heavily into stocks, with the understanding that “their portfolio is slightly more volatile, bonds are slightly less valuable as a hedge, and the way to compensate for that incremental risk is actually to increase the portfolio’s expected return by owning more stocks,” Weisberger said.
There may also be more room for additional asset classes that bring greater risk, such as commodities, aimed at compensating for greater volatility, he said.
Weisberger warned against using 2022 as a paradigm for markets going forward. The wholesale re-rating of both stocks and bonds in tandem was highly unusual, he said, and investors should not assume the continuation of persistently negative returns for both asset classes.
“In 2022, the performance of a balanced portfolio was less about the shift in correlation from negative to positive,” Weisberger said. “It was much more about really bad realised returns.”
He noted stocks and bonds will likely not be very highly correlated even in a regime of positive correlation, and “there’s plenty of room even within that positive co-movement for the two assets to be diversifiers.” Moreover, with history as a guide, even in the context of a positive correlation regime, bonds could still outperform when equities underperform during crisis periods due to a “flight to quality,” he said.
Unless the terrible returns of 2022 continue, which is doubtful, we are unlikely to witness the death of the 60/40 portfolio, he said. “A portfolio with multiple assets that are moderately correlated still is the right place to go for a risk averse investor.”
Weisberger’s previous research found stock bond correlation regimes are very long lasting, with the current 20-year period of negative correlation following almost 30 years of positive correlation from the late 60s. They are also very similar across developed markets, which typically move together.
Those papers concluded that periods of positive correlation tended to coincide with concerns about fiscal policy sustainability, concerns about monetary policy independence where monetary policy “seems to be driving the cycle as opposed to responding to the business cycle,” and where “investors are re-rating risk in tandem across asset classes.”
A world of positive correlation between stocks and bonds leads to more volatile portfolios, impacting the performance of a balanced portfolio, Weisberger said. This is not because stocks or bonds are more volatile themselves, but because portfolios will no longer be benefitting from the stronger built-in hedge provided by the negative correlation between these two asset classes.
In a world of positive stock-bond correlation, “portfolio managers and CIOs should expect their balanced portfolio to have higher per period volatility, they should expect their portfolio to have a wider range of risk-adjusted returns–even over long periods of time, a wider dispersion of terminal wealth outcomes, deeper drawdowns, and greater probability of ending a given period of time…in the negative,” Weisberger said.