Erik Knutzen, Neuberger Berman
“The biggest thing that investors are not focused on right now is this changing correlation between stocks and bonds,” Knutzen told FSA during a recent visit to Hong Kong.
Investors have become accustomed to investing in stocks and investment grade fixed income, he explained. However, the correlation between the two asset classes has been increasing, especially in an environment of rising interest rates. “That is what investors are least prepared for right now.”
According to Bloomberg data, the correlation between equity and bond prices has increased this year. For example, the correlation between the Bloomberg Barclays Global Aggregate Total Return Index and MSCI ACWI Net Total Return Index rose to above .20 in mid-March from just below zero at the beginning of the year.
Rising inflation expectations as well as increasing interest rates are risks that Knutzen is monitoring. “There is a lot of noise around a trade war, noise around Trump and North Korea, but the important signals are what central banks are doing and their impact on interest rates and inflation, and that is what we are watching most closely.”
Index put strategy
Because of rising inflation and interest rates, the market has become more volatile compared to the “Goldilocks” environment that investors were in last year, Knutzen said.
Knutzen’s team has therefore replaced some of its equity exposure with equity index put writing. In terms of percentage changes, Knutzen said that it depends on the firm’s multi-asset portfolio. It could be little as 2%-3% or could be as high as 5%-10%.
“What we’re doing is we’re writing ‘at-the-money in options on equity indices put options,’” he said.
In simpler terms, he explained that it is like writing insurance and capturing insurance premiums on equity indices.
The strategy can earn 1% a month, which translates to 12% a year, he said, and acknowledged that it is less attractive than the 22% returns of the S&P 500 in 2017. However, although he is still positive about the equities markets, he is more concerned about the downside this year because of higher volatility.
“This strategy tends to do well when volatility is higher and it tends to protect more on the downside as it has lower volatility,” he said. For example, during the global financial crisis in 2008, index put writing was down by around 30%, while equity markets were down 52%.
Source: Neuberger Berman
“It seems unlikely that we get an upside surprise, most likely that we get a lower positive returns on equities,” he added.
Another adjustment is a shift away from US equities and into emerging market, Europe and Japan equities.
“We think that we are now in a late-cycle reflationary growth environment. We still want to be biased toward equities rather than fixed income, but we want to be in markets that are earlier in the cycle.”
For the team’s fixed income allocation, Knutzen said that it has been reducing interest rate sensitivity and repositioning toward inflation-sensitive assets.
Traditional government bonds and investment grade bonds have become more correlated with equities, Knutzen said. These bonds also have less to offer in terms of diversification because they now carry more interest rate risk.
“We are repositioning a portion of our traditional interest rate exposure into shorter-duration exposures and we’re allocating into US Treasury Inflation-Protected Securities,” he said.
Performance of one of the firm’s multi-asset funds, the Multi Asset Class Income Fund, versus its sector.
Note: Fund and sector NAVs have been converted to US dollars for comparison purposes