Regime shift: what it means for strategic asset allocation

Strong gains from both equities and bonds have propelled aggregate returns since the global financial crisis in 2009. But in 2022, equities and bonds both experienced woeful performance in the face of inflationary and growth concerns. For a standard “60/40” portfolio (60% global equity and 40% bonds) 2022 was the worst year on record (-14.4%) over the last 50 years, aside from the global financial crisis.

Asset owners and investors face a new regime in which bonds may no longer protect portfolios from the falls in equities. Various macroeconomic mega-trends are likely to have greater influence on future returns. There are understandable concerns about whether portfolio construction approaches that have worked for decades should be reconsidered.

Several major trends will shape the investment outlook over the medium-term, which collectively we describe as “regime shift”.

1. Central banks will prioritise controlling inflation over growth
2. Governments will respond with more active fiscal policy
3. Further challenges to globalisation will arise
4. Companies will respond to higher costs by investing in technology
5. The response to climate change will accelerate

Here we look at the investment implications of regime shift on liquid assets, the impact it has had on correlations and how investors should take account of these themes.

Recap: what has happened to 60/40 performance and correlations?

For a portfolio consisting of 60% equities and 40% bonds, 2002, 2008 and 2022 were years that saw the most severe drawdowns (Figure 1). Otherwise the approach has been broadly successful, providing investors with positive returns most of the time. Years with negative performance are also usually followed by a strong rebound.

Figure 1: 60/40 has been successful in most years

The 60/40 portfolios have been popular not just for their positive returns but because the correlation of equities and bonds have been negative since the turn of the millennium, resulting in a strong diversification effect.

Using US equities and US government bonds in our models, Figure 2 shows that while equities provide the greatest annualised returns over time, on a risk-adjusted perspective the 60/40 portfolio delivers strong numbers, particularly from a nominal perspective.

A similar story can be seen for a 60/40 portfolio comprising of global equities and global government bonds.

Figure 2: The diversified portfolio provides better risk-adjusted returns

Where have equity-bond correlations gone…

When it comes to equity-bond correlations, investors are primarily concerned about whether bonds will continue to provide similar levels of protection in their portfolios as in the past. When correlations are negative, bonds provide a cushion when equities fall.

Naturally, investors don’t mind positive correlations when both equity and bonds provide positive returns. However, when equity-bond correlations turned positive in 2022 driven by inflationary pressures, growth and volatility shocks, depressing both equity and bond valuations, asset allocators scrambled for shelter.

… and what does this mean for portfolio construction?

It’s important to understand why the new regime has resulted in positive correlations. Surprise in growth expectations is positive for equities but negative for bonds resulting in a more negative equity-bond correlation.

However, surprise in inflation expectations is negative for both equities and bonds which gives rise to a more positive equity-bond correlation. The net impact on these opposing forces on the equity-bond correlation will largely depend on whether inflation or growth surprises dominate in a given market environment.

The following asset classes are less impacted by surprise in growth and inflation expectations and therefore are likely to be more important in portfolio construction if the market remains driven by inflation risk, and equity-bond correlation remains positive:

• Commodities – driven more by supply/demand factors than growth and inflation shocks.
• un-constrained dynamic strategies that seek to harvest returns from systematic exposures, and which benefit from macro volatility. This may also provide greater diversification and drawdown protection to portfolios during periods of positive equity-bond correlations. However, identifying strategies that consistently produce returns above cash is not straightforward and often requires considerable governance expertise, so this may not be practical for all investors.

The role of bonds in the new regime

More persistent inflation, a move away from quantitative easing and the return of the interest rate cycle suggests that bond performance will be more variable over the cycle.

In Figure 3 we show the performance of the key asset classes over the stages of the economic cycle.

(The cycle is determined based on the output gap, which is the difference between an economy’s actual output and its potential output. Expansion: Output gap is positive and rising. Slowdown: Output gap is positive and falling. Recession: Output gap is negative and falling. Recovery: Output gap is negative and rising.)

As can be seen, bonds have delivered positive performance on average in every stage. In the last regime, interest rates were zero or even negative and so quantitative easing was increasingly used. In the new regime, we believe that bonds will continue to be great performers in the recovery and recession phases, but performance could be more challenged in the expansion and slowdown phases as rates rise.

With the return of the rate cycle, and assuming that it is in sync with the growth cycle, central banks should start hiking rates in expansionary periods and follow through in slowdowns (poor bond performance), and cut rates in recessions and continue with loose monetary policy in the recovery phase (strong bond performance).

Figure 3: The performance of asset classes through the economic cycle

We believe that bonds will still warrant a strategic allocation but the actual exposure within portfolios will now need to be managed more actively due to this new regime. Additionally, we expect the volatility of bonds to return to a more “normal” level – roughly the long-term average volatility of the years prior to 2009 (i.e. prior to when quantitative easing was introduced and had started to work). As a result, investors will require higher compensation (i.e. yield), as shown in Figure 4. And if bonds are no longer consistently negatively correlated with equities, investors will need to think of them playing a different or modified role in the portfolio – one that is more focused on yield than diversification.

Figure 4: Yields are beginning to outweigh diversification benefits

Cash – further yield provision

In nominal terms, cash rates are expected to be considerably higher than in the last regime as central banks are unlikely to return to negative or zero interest rates. This can be seen in Figure 4 where cash yielded 4.4% p.a. at 31 December 2022, while only 0.1% p.a. a year before. As with bonds, cash instruments (US 3-month treasury bills, for example) will continue to have higher yields than in previous years if central banks keep rates high to successfully bring inflation down to target (say 2% p.a.). If inflation is expected to persist, then cash could play a larger part in portfolios.

However, quantitative tightening will remove or reduce excess liquidity and this could result in risk and inflation premiums returning to traditional asset classes, making them more attractive relative to cash. We believe it is unlikely that cash should form part of the strategic asset allocation, but it could be used more effectively on a tactical basis than before the regime shift.

Equities: a more discerning approach will be necessary

Following years of zero-rate central bank policy and quantitative easing, in the new regime equities will be driven more by fundamentals.

The regime shift trends covering technology, globalization, decarbonization and higher interest rate are all likely to impact asset allocation within equities. It is difficult to ascertain if these trends will change economic growth overall because each trend is dependant on structural arrangements by country. For example, countries with poor demographics and a shortage of labour should see more investment in robotics, automation and AI. Companies that can embrace this trend, and are less labour intensive should be winners. Those that can’t and are more labour intensive are likely to be losers. The relative weight of the winners and losers will impact growth for the technology trend in a particular country.

Technology

With greater scarcity in resources and associated higher costs, a surge of investment in technology and structural changes to supply chains and energy policy will create opportunities among a new wave of companies. Some of the investment themes that have emerged in the last few years will only strengthen – and new ones will emerge. This will require asset allocators to consider “themes” as part of their allocation. Additionally, investment in new areas are often opportunities for private equity investments, not just public equity.

Challenges to globalisation

Deglobalisation will lead to more trade friction and reshoring or ”near-shoring” (e.g. US pulling manufacturing from Asia to Mexico). Some regions will benefit, others will be losers. Additionally deviations between countries’ monetary, fiscal and energy transition policies will create more regional divergence.

In Figure 5, we can see that the global goods trade (sum of imports and exports, as a percentage of global GDP) peaked in 2008 and has struggled to recover since. Deglobalisation has often been touted as the cause, as countries seek to produce goods they need domestically and rely less on foreign counterparts.

Figure 5: Global trade peaked in 2008

Higher interest rates

Higher rates will also impact “zombie” companies that survived due to low borrowing costs but will likely struggle going forward. Identification of these companies, and those that are able to pass on higher costs to their consumers, will be imperative and will not be achieved by investing in indices that reward the successful companies of yesterday. In sum, the new regime will require greater use of active fund management.

Net zero

Transition to net zero requires a fundamental transformation of the world economy and significant investment. In McKinsey’s in-depth analysis of the transition to net zero (The Transition to Net-Zero, January 2022), it calculates that ”capital spending on physical assets for energy and land-use systems in the net-zero transition between 2021 and 2050 would amount to about $275 trillion, or $9.2 trillion per year on average, an annual increase of as much as $3.5 trillion from today.”

Specific parts of the equity market are likely to benefit from this transition, such as renewable energy, battery storage and grid development, but valuations in these companies need to be carefully analysed.

Figure 6 shows the expected shift towards consuming renewable energy in the future.

Figure 6: Global primary energy use shifting to renewables

Real Estate Investment Trusts: watch out for interest rate sensitivity

Real Estate Investment Trusts (REITs), although not fixed income instruments, are also interest rate sensitive assets. If we look at REITs, they seem to do well during recession and recovery when interest rates are low (see Figure 3), which helps stimulate demand and the recovery in house prices and rents.

During expansion and slowdown, higher inflation generally results in higher interest rates which hurt the performance of REITs. Also, during expansion, investors tend to rotate towards the more cyclical areas of the market and move away from the more defensive characteristics of REITs.

Figure 7 supports the analysis above. We see that REITs have a negative correlation with changes in US 10-year government bond yields most of the time. Although the yields on REITs are likely to rise with higher bond yields, this is more than offset by the fall in the price of REITs.

Figure 7: Correlations between REITs and government bonds are usually negative

Commodities as a strategic allocation

A number of the new regime factors are positive for commodities. More persistent inflation, reshoring, geopolitical tension, transition to net zero and concerns about positive equity-bond correlation all argue for considering a strategic allocation to commodities, taking into account the risk budget of the portfolio.

As can be seen in Figure 8, commodities deliver positive returns most consistently in high and rising inflation environments, and high and falling inflation environments. However, it should be noted that this analysis is limited as there have been no periods of extreme inflation as was experienced in 2022 in this sample timeframe.

Figure 8: Commodities are better suited to higher inflation environments

As mentioned earlier, commodity markets are driven more by supply/demand factors than growth and inflation shocks. But as we have seen with the Ukraine war and the US-China trade dispute, closures of transport routes can adversely impact the production or transporting of a particular commodity. This in turn can lead to supply shortages, increased price volatility and opportunities to invest selectively.

In addition to specific equity sectors that will benefit from the transition to net zero, commodities (specifically base metals such as copper and nickel and rare earth elements) will be in significant demand.

Finally, if the equity-bond correlation remains positive (or even less stable), commodities will be important in portfolio construction because they are less impacted by surprise in growth and inflation expectations (which impact equities and bonds).

Are there opportunities in currencies in the new regime?

Most investors setting their strategic asset allocation would not include currencies as a separate part of their allocation. Instead they have a neutral, strategic currency position as their base currency portfolio.

Since currencies are a heterogeneous group, correlating differently with different asset classes at different times, portfolio managers can use them tactically to position for shorter term risks and opportunities, as we discussed in our paper on ‘The role currency plays in multi-asset portfolio’. We believe that there will be more currency volatility in the new regime and that this will provide tactical opportunities for investors to allocate selectively to different currencies.

Summary

It’s been an unsettling time for asset allocators post-Covid in a new regime world of high inflation and interest rates and positively correlated equity and bond markets. Over the medium term we see the following shifts in asset allocation as a result of the new regime:

Correlations – if you believe that:

• Correlations will remain positive – consider including commodities and other alternative risk premia as part of a core allocation
• Correlations will return to a negative relationship – diversification remains important but there will be less necessity for asset classes not driven by macro factors. Together with lower expected returns, investors will need to work harder to generate returns, which means both more diversified approaches to generate returns and also more focus on alpha.

Bonds – will still warrant a strategic allocation but may not be the diversifier of the past. The return of the interest rate cycle suggests that bond performance will be more variable over the cycle and exposures around the benchmark will need to be managed more actively.

Cash – higher rates with little duration and counterparty risks will allow cash to play a bigger role in portfolios, but most likely on a tactical rather than strategic basis.

Equities – a number of the new regime factors are likely to impact equities. Investors will need to be more selective about the regions and companies that will benefit from technology, energy transition and deglobalisation. Themes will need to be considered as part of the asset allocation decision.

Commodities – A less stable equity-bond correlation, more persistent inflation, geopolitical tension and transition to net zero all point to benefits for commodity investment in the medium term. Asset owners should consider including commodities in their strategic asset allocation, taking into account their risk budget.

Currencies - Deviations in monetary, fiscal and energy transition policy will create more regional divergence which can be exploited tactically.

Valuations – while not covered in this paper, valuations have a significant role to play in whether an asset class should be over/underweighted from a tactical perspective over the shorter term.

In the portfolio construction process, it is imperative to understand how various asset classes interact with each other. With equity-bond correlations where they are at now, portfolio constructors will need to relook at their processes, in particular how they can incorporate assumptions of positive equity-bond correlations using a forward-looking approach to risk management. This may mean conducting ‘what-if’ scenarios on their portfolios that include a forward-looking assumption of positive equity-bond correlations, rather than just relying on a smoothed average correlation from the past. It will also mean that asset owners will need to dynamically manage their asset allocation relative to their strategic benchmark if correlations are unstable.

Appendix: Is it possible to predict correlations?

For many years the correlations between equities and bonds have not been top of an asset allocator’s agenda. They have been in negative territory since 2000 and so, for portfolio construction purposes, an average (negative) correlation over, say, the last 10 years served as a suitable correlation assumption for the future.

But research[1] carried out in the early 2000s, when correlations had just switched from positive to negative, concluded that expectations of inflation, growth, rate policy and volatility are the factors that influence correlations and make them hard to predict over shorter horizons – especially during inflection points as we are currently experiencing.

It is worth noting that over the longer term, the equity-bond correlation does go through regimes as shown in Figure 9. More recent research,[2] conducted as correlations switched from negative to positive, confirmed earlier research that the relative volatility of growth and inflation impacts the correlation between equities and bonds. It also highlights that if central banks are successful at curbing inflation, the correlation is likely to move back to being negative again. But if central banks are unsuccessful, or if supply shocks are more prevalent moving forward, the correlation is likely to stay positive.

Figure 9: Different regimes for equity-bond correlations

We have also considered whether the stage of the economic cycle can tell us anything about predicting correlations. Based on data going back to 1950, one thing that stood out is that correlations typically reduce during recessions when equities sell off but bonds perform better (see Figure 10).

However, as highlighted earlier, surprise in inflation and growth expectations and the relative amount of surprise between these two factors has the greatest impact on the correlation between equities and bonds.

Figure 10: Average equity-bond correlation across economic cycles

[1] Stock-Bond Correlations – Anti Ilmanen, Journal of Fixed Income, Fall 2003

[2] A Changing Stock-Bond Correlation: Drivers and Implications – Brixton, Brooks, Hecht, Ilmanen, Maloney & Quin, Journal of Portfolio Management, Multi-Asset Special Issue 2023