Portfolio theory, in practice

A maxim of investing, taught to us from the very first of our portfolio theory classes, is that equities and fixed income should display a negative correlation. The simple version of the theory states that equities appreciate in times of economic growth and fixed income provides protection when fear abounds. This is a dramatic oversimplification. As the last month made abundantly clear, many types of fixed income carry risk more akin to equities. In addition to this, the OECD (Organisation for Economic Co-operation and Development) estimates that global GDP growth for 2022 was 3.2%[1], yet equity markets displayed negative returns. Given this backdrop, we must answer 2 simple questions: how does asset class diversification add value in a portfolio and can we expect fixed income to provide us with protection in a risk off market in the future.

Firstly, we return to portfolio theory to understand why investors hold bonds for protection. Capital Market Theory holds that investors have the ability to allocate to a risk-free asset or demand a premium (by way of returns) for taking additional risk. In common parlance the risk-free asset is a government bond, usually the 10-year Treasury. As the European debt crisis of 2011 showed, government bonds are not without risk and the upcoming US debt ceiling negotiations may test the faith of global investors in the relative riskiness of Treasuries. However, given the opportunity set of global investments, Treasuries are as near to a risk-free asset as possible. It is worthwhile stating here also, we do not believe that the US government will default on its debt this year.

The period since the collapse of Lehman Brothers in 2008 has been marked by monetary repression and near zero interest rate policy in a significant portion of the world. In this environment, yields on government bonds have continually declined while equity valuations have been inflated due to the higher value today of earnings in the future. When this set of conditions changed last year, however, equity valuations needed to adjust rapidly while bond yields increased to account for the higher prevailing rate environment. We also saw this during the so called “taper tantrum” of 2013 when the Federal Reserve (Fed) ultimately changed monetary policy in response to a market selloff after the announcement that the Fed would start to reduce their programme of asset purchases. In 2022 however the Fed believed that the threat of embedded inflation was sufficient to continue their monetary tightening programme as risk assets sold off, as we have discussed in other editions of The Brief. Through this lens, it is perhaps better to state that equity markets failed to diversify a bond selloff rather than the more commonly accepted converse.

Research has also confirmed this reading, in that fixed income diversifies returns during an equity market selloff but equities fail to do the same during a bond market selloff[2]. This makes intuitive sense both due to the relationship between bond yields and equity valuation as discussed above and the long-held faith of the market in government debt as a risk-free asset. This is, in fact, why we hold government bonds in portfolios and in the past month, when fear was abundant in global markets and equity markets declined, these instruments acted as expected and provided protection to portfolios.

[1] https://www.oecd.org/economic-outlook/march-2023/

[2] https://www.tandfonline.com/doi/full/10.2469/faj.v74.n3.3