Stockholm (HedgeNordic) – The relationship between equities and bonds has traditionally been inverse, making bonds a leading choice as a diversifier to an equities portfolio. 2022 wasn’t a normal year in that respect. For much of 2022, the impact of rising inflation and interest rates created a rare anomaly where both equities and bonds incurred losses at the same time.
At this year’s media and investor conference of French asset management firm Carmignac in Paris, HedgeNordic sat down with one of the investment committee members, Kevin Thozet, and discussed what led to the breakdown in stock-bond correlation in 2022 and how the correlation might look going forward. Thozet also pointed out the importance of an active, cross-asset investment approach amid the return of the economic cycle, and highlighted the rising potential of long/short equity investing.
The Stock-Bond Correlation in 2022 and Ahead
“We don’t often see bond and equity prices being positively correlated on the downside and upside. The main reason for this is inflation,” argued Thozet. “When central banks are running behind inflation, your traditional safe assets, which are fixed-rate bonds issued by well-rated issuers, are not going to work as defensive assets because of the risk and uncertainty of higher interest rates,” he elaborated. Another reason for the lack of defensive attributes from bonds in 2022 was the level of bond valuations – or the low nominal yields which prevailed as the most synchronized and abrupt hiking cycle kicked in.
“We don’t often see bond and equity prices being positively correlated on the downside and upside. The main reason for this is inflation.”
The yields on investment-grade bonds had been close to zero for a long time, making such bonds vulnerable to any minor increase in interest rates. “If you have a corporate bond portfolio yielding 0.5 percent with a duration of five years, even a small move in interest rates can lead to losses,” explained Thozet. With bond yields much higher and modified durations much lower at the moment, there is lower sensitivity to interest rates, according to Carmignac’s investment committee member. “One can absorb much more volatility in interest rates before losing money because of the high carry returns, the higher yields bonds are offering.”
The higher yields offered by bonds in this environment will lead to a negative correlation between equities and bonds in the face of further central bank monetary tightening. “Short term, say between now and the coming six months, equities and bonds should be negatively correlated,” said Thozet. Longer term, the correlation between bonds and equities hangs on a multitude of conditional expectations that make prediction difficult and path-dependent.
The Return of the Cycle
The very accommodative monetary conditions post the financial crisis of 2008 may have averted a more serious crisis. The unconventional policy tools rolled out by central banks may also have interfered with the normal business cycle. “Central banks “killed” the economic cycle in the aftermath of the great financial crisis and the European sovereign debt crisis,” argued Thozet. The unwinding of central bank stimulus marks the return of the business cycle. “That is something which is clearly changing and is changing for good.”
“Central banks “killed” the economic cycle…That is something which is clearly changing and is changing for good.”
With the return of the business cycle, active managers can start using their allocation compass again, according to Thozet. “When you have an economic cycle, as an active manager you can anticipate when growth or inflation will roll over and position your portfolio accordingly,” explained the member of Carmignac’s investment committee. “You find your compass again. If growth is rolling over, perhaps we need to take some money out of the table and divest a bit from value and cyclical assets into more growth or defensive names.”
The desynchronization of inflation and economic growth around the globe also creates a fertile environment for active, cross-asset managers. “We observe very desynchronized growth around the world,” confirmed Thozet. Growth expectations for the US economy in 2023 stand around one percent, around zero percent for Europe, and 4-5 percent for China. “China will be the only place in the world where economic growth will be higher in 2023 than in 2022. Europe and the United States will face lower economic growth whether we observe a recession in the US or not,” he explained.
“We can see desynchronization both on the economic growth side and on the monetary policies side.”
“In terms of synchronization, the US has not entered into recession yet, Europe is already – or very close – out of recession and China is about to benefit from a reopening boom,” said Thozet. “We can see desynchronization both on the economic growth side and on the monetary policies side,” he continued. “For an investor with a top-down, global view as ours, 2023 offers fertile grounds to implement an active, flexible, and cross-asset strategy.”
Equity Long/Short on the Rise
Carmignac, which has predominantly focused on running active strategies focused on multi-asset, fixed income and equity, is also active in the alternative, hedge fund space. The French asset manager has operated a European-focused long/short equity strategy for years and sees more opportunities in the space. “The end of free money means much more dispersion, which means you have winners and losers that are no longer kept artificially above the surface,” Thozet told HedgeNordic on January 19 in Paris. “With the evolution in terms of volatility in the economic cycles comes volatility in financial markets. We see lots of opportunity going forward in the long/short equity space.”
