Global equity and bond markets can continue to deliver decent returns despite their respective rallies thanks to central bank intervention, according to Pictet’s Andrew Cole, who says that traditional fixed income assets can also continue to diversify against equity market risk despite growing concerns. 
The advent of ultra-low interest rates and quantitative easing to re-invigorate economic growth has had a profound effect on financial markets, as by buying their own government’s debt, central banks have forced investors into the equity market in search of returns and yield.
The ramification of this means both fixed income and equity markets have delivered stellar returns since the end of the global financial crisis, but correlations between the two asset class have spiked to historically high levels as a result.
This trend has only intensified over recent months, as the graph below shows.
Performance of indices since EU referendum
Source: FE Analytics
While equities initially fell following the historic Brexit vote while gilts rallied on thanks to a general flight to safety, the two indices have been moving in upward and in tandem ever since.
Sterling weakness has clearly played its part, but another factor has been the Bank of England’s policy response as by slashing interest rates to 0.25 per cent and starting a new QE programme, extra-liquidity has forced bond yields lower and equity prices higher.
There are many, therefore, that warn this cannot continue.
On the one hand, some believe bonds are so vastly overvalued that investors are guaranteed to lose money from them over the longer term. On the other, various market commentators warn the equity market rally is heading for an abrupt end as it hasn’t been driven by fundamentals and as complacency is rife among investors.
However, Cole – manager of the FP Pictet Multi Asset Portfolio – says that as central banks will continue to remain as supportive as humanly possible right across the world given poor economic growth and stubbornly low inflation, both bonds and equities can continue to perform well.
“Central banks are in no hurry to raise interest rates and this is partly due to government policy, keeping bond yields low for as long as possible so that governments can inflate debt away,” Cole said.
“This means that, along with a lack of inflationary impulses, bond yields are going to remain low and in a tight trading range for the time being. We would agree that they are not cheap (they are pretty damn expensive), but in the current environment, why wouldn’t equities get as expensive as bonds?”
“People always tell me that equities look expensive – but they clearly haven’t been looking at bond yields.”
10yr gilt yields over 10yrs
Source: FE Analytics
“Yes, there may well be a day of reckoning where we have a secular bear market in bonds and equities. However, inflation is subdued, economic growth is slow (but improving) but earnings growth is increasingly positive.”
However, the main goal within a multi-asset portfolio is diversification – the idea that investors can limit their losses by holding a collection of lowly-correlated assets, as they can mitigate the chances of all of their assets falling in value at the same time.
As FE Trustnet showed in a recent article, though, correlations between equities and bonds have increased markedly over recent times – presenting the worrying thought of ‘what goes up together, must come down together’.
Indeed, this is why a variety of market commentators warn that it has never been harder to build a diversified portfolio than today.
“While circumstances are such that it is hard to see any significant changes in the interest rate environment, it is perfectly possible that investors could be caught by surprise by higher rates just as they have been continually caught by surprise by the extent to which rates have fallen,” Hawksmoor said in a recent note to investors.
“These are not normal times, and we believe the traditional model of a balanced portfolio that consists of a mix between high quality bonds and equities is a dangerous approach because the performance of the two asset classes is becoming increasingly positively correlated,” the team added.
According to FE Analytics, a traditional asset allocation mix of 60 per cent equities and 40 per cent bonds has delivered stellar risk-adjusted returns over the longer term.
Performance of model portfolio versus indices over 25yrs
Source: FE Analytics
Our data shows, for example, that by implementing that blend over 25 years, investors would have beaten the returns of bonds by some 150 percentage points but significantly reduced the maximum drawdown and annualised volatility (as well as upping their Sharpe ratio) that they would have seen by holding just equities.
Of course, that relationship has only worked in such a way due to the fact that bonds have tended to rise in value when equities have sold-off. 2008 was one of the best examples, when equities lost 28 per cent but gilts rallied by 12 per cent.
Nevertheless, Cole says a more traditional approach to asset allocation can still work.
“We agree, in theory, that for most of the time and mixture of government bonds and equities gives you the best risk-adjusted return profile. That is the case in theory and has historically largely been the case – it’s just when it isn’t, it bikes hard.”
He says there have only been a few extreme examples where this blend hasn’t worked.
One of the most prominent was in 1994, when Alan Greenspan’s US Federal Reserve unexpectedly raised interest rates which, in turn, caused a sell-off across bond and equity markets. That year, the traditional asset allocation lost 8.21 per cent.
Performance of model portfolio versus indices in 1994
Source: FE Analytics
However, Cole says that was an extreme example and argues the only reasons bonds and equities will fall together going forward is if inflation starts to rise dramatically – an outcome he thinks is very unlikely at this stage.
“We still see the diversification benefit of long-dated government bonds. We are not fearful of owning them.”
