The return of inflation as a significant problem in 2022 sparked large losses across both bond and equity markets, and while it has since declined from its highs, Gopi Karunakaran believes inflation uncertainty remains elevated and could see a reprisal of the 2022 environment.
Speaking to InvestorDaily, the co-chief investment officer at Ardea Investment Management said there are realistic forward-looking scenarios in which inflation stops falling – or indeed starts rising again – which would be negative for both equity and bond markets.
“Elevated inflation uncertainty has changed the bond/equity correlation, making it more unstable and, more often, a positive correlation. As inflation uncertainty is likely to remain for some time, we can characterise this changing correlation behaviour as a regime shift rather than just a temporary disruption,” he said.
According to Karunakaran, this regime shift impacts the traditional role of long-duration government bonds as a safe haven asset because it makes bonds less reliable and less effective as a defensive risk diversifier for equity.
“Bonds play their safe haven role most effectively when they have both low volatility and low correlation versus equities. The regime shift to a more uncertain inflation environment has made bonds more volatile and made the bond/equity correlation more variable,” he said.
This, however, does not mean long-duration government bonds are no longer useful as a diversifier, Karunakaran said, noting they can still be useful in certain scenarios, including an economic growth shock.
But given the converse is also true, he stressed that “simply relying on long-duration government bonds as the sole diversifier for equity risk is not a good idea”.
“The key takeaway is that portfolio construction should not be overly reliant on long-duration government bonds as the defensive diversifier for equity risk,” Karunakaran said.
“Relying on just the single lever of duration to diversify equity risk embeds an implicit macro forecast about what types of macro scenarios are likely going forward. This [is] a risky bet to make given how unreliable macro forecasting is in general, and particularly so in regimes of elevated inflation uncertainty.”
An alternative approach, he noted, is to reduce reliance on macro forecasting by instead focusing on building portfolios that are resilient to a wide range of possible outcomes.
“This means broadening the risk diversification tool kit to complement the conventional duration lever with other investments that exhibit the following attributes: low downside volatility, low equity market correlation, strong defensive bias to outperform when equity (and bond) markets incur losses, attractive standalone risk versus return profile (positive expected return from genuine alpha),” Karunakaran said.
Highlighting “consistency of behaviour” as key, he added: “There’s not much point having a portfolio risk diversifier that exhibits these attributes in the good times but becomes equity-like in the bad times”.
“That’s like an umbrella that only opens on sunny days … it’s not fit for purpose.
“Reliable risk diversification comes from adding investments whose underlying return drivers are genuinely different to the factors that drive equity returns, particularly in extreme scenarios.”
But Karunakaran cautioned investors to also be wary of investments labelled as “alternatives”, noting that while some may look “sufficiently different” to equities on the surface, in reality, they can end up behaving like equities when markets fall.
“Therefore, it is important to look beyond labels and understand the actual underlying drivers of an investment’s returns, and how those drivers are likely to impact performance in different equity market scenarios.”
