Icarus, the Greek mythological character who attempted to fly off the coast of Crete with a set of wings constructed by feathers bound together by wax, was warned by his father to be aware of two major risks: the sea, as getting too close would soak the feathers, and the sun, as flying to high would melt the wax. 
As in the Icarus myth, investors today should be mindful of two risks, inflation and volatility. The current low level of inflation and an expectation of a benign future path is providing a positive background for bonds and equities, but as the recent market plunge shows us: nothing is certain.
As we know, the traditional relationship between bond prices and interest rates is one of inverse correlation.
The level of interest rates is determined by a number of factors, such as economic growth and the status of the labour market. In the recent past, the key driver has become inflation, or more precisely the low level of inflation, and low expectations for the future, which implies that rates will drift upwards slowly.
Low inflation can be seen both in the disappointing December data in Europe and in the Federal Reserve’s Beige Book, where inflation expansion is described as modest-to-moderate, as well as in the low compensation that investors demand for holding bonds.
This environment has so far been positive for bonds as it reduces fears of losses from sharp moves in interest rates.
Markets were ripe for an explosive spike
Low inflation is also positive for equities. One way to price equities is to divide future profits by the prevailing interest rate over the period, which implies that a rise in interest rates would make equities worth less today.
High valuations though, as currently indicated by the cyclically adjusted price/earnings (CAPE) ratio, make equities more vulnerable to a correction, even though in the current environment of low inflation expectations, the potential for rates to increase is limited.
The low level of volatility, which had been puzzling markets, was ripe for an explosive spike. The Chicago Board Options Exchange SPX volatility index (VIX), which reflects a market estimate of future volatility, has been extremely low for the past few years.
As mentioned in the June 2017, Federal Open Market Committee (FMOC) minutes, “a few participants expressed concern that subdued market volatility, coupled with a low equity premium, could lead to a build-up of risks to financial stability”.
Decreased volatility during business cycle expansions may lead to lower risk constraints for investments (e.g. value-at-risk) and increases in leverage. The consequence we all saw was a small shock in volatility, which led to a dramatic correction.
Engineering a balanced approach
When equity valuations reach lofty heights, a fixed income allocation is needed in order to balance risks effectively.
This can take many forms: inflation protection bonds protect from inflation increases, government and investment grade bonds offer very low correlation to equities (the 25-year correlation between the S&P 500 and 10-year Treasuries and investment-grade bonds is -0.19 and 0.22 respectively), subordinated bonds are characterised by attractive yield, high quality and the ability to absorb interest rate increases, and finally high yield (on top of the ability to absorb interest rate increases) offers similar returns to equities over time, with less than half the volatility and the benefit of seniority in the capital structure.
The desire to achieve beyond boundaries is essentially human, but in order to avoid the unfortunate fate of Icarus, investors need to remember the importance of a diversified investment approach that includes an allocation to fixed income. The market is a not a straight-line and investors must remember to protect their feathers.
Michalis Ditsas is an investment specialist for fixed income at SYZ Asset Management. All views are his own and should not be taken as investment advice.