iStrat is the investment strategy and solutions group within Wellington. We are allocators and investors, like our clients. So, where do we think the investment focus should be in the coming year? I’ll highlight three areas that are top of mind:
1. Seeking downside mitigation as the equity/bond correlation remains unstable
Over the last few decades, the negative correlation between equities and bonds has provided an excellent balance to many allocations. This last year saw both markets decline, and this positive correlation turned the equity/bond relationship from risk-mitigating to risk-additive.
As our team explained in a recent article, the shift in correlation was driven by the evolving economic environment. Over the past decade, markets came to assume that central banks would respond to any deterioration in macro conditions by cutting interest rates and doing, as former ECB President Mario Draghi once put it, “whatever it takes”. This helped maintain the negative correlation: a struggling economy is negative for equities but positive for duration when the response is lower rates. But now central banks face higher inflation, setting up the potential for a difficult choice: loosen monetary policy if the economic outlook worsens or hike rates to stem inflation. Bonds will struggle in this environment and especially if central banks are perceived to be behind the curve in the inflation fight.
We think inflation will remain a challenge (even if it’s not at current 40-year highs) and central banks and governments will be forced to wrestle with this growth/inflation trade-off. While bonds may still play an important role in portfolios given their potential for income, liquidity and total return enhancement, this high-inflation regime may limit their diversification and downside protection roles. To prepare, allocators may want to consider strategies that can complement the protective role of bonds, including:
- Defensive hedge fund allocations — Our Fundamental Factor Team has looked at how hedge funds can potentially help fill the same roles as traditional fixed income allocations. They found that macro hedge funds may be best aligned with the fixed income roles of diversification and downside protection in different rate environments (read their research here).
- Defensive equity allocations — As allocators consider ways to use their risk-seeking allocations to compensate for the reduced diversification and downside protection of fixed income, we are seeing renewed interest in defensive equity allocations to complement growth and value, many of which have done well in 2022.
- Active risk control — Another part of the solution may be taking more control of risk levels in a portfolio. One approach our Multi-Asset Team thinks is worth considering is actively adjusting portfolio hedges as the perceived probability of a market decline fluctuates. For example, if the probability of a near-term drawdown is elevated, various protective strategies (e.g., options, beta hedging, volatility-control mechanisms) may be implemented to potentially help mitigate some of the downside loss even if the correlation between equities and bonds remains positive.