As correlation norms turn, liquid alternatives come to the fore
While the economic community is aghast at the sudden correlation of bonds and equities since 2022, this is just a cyclical reversion according to P/E Investments managing director Andrew Harrex. The need for alternative diversifiers to both will remain for years to come, he believes, and that’s just one of the significant tailwinds gusting behind liquid alternatives.
Speaking to a room full of financial advisers, fund managers and analysts at The Inside Network’s 2023 Alternatives Symposium in The Rocks, Sydney on Wednesday, Harrex (pictured) explained how the communal hand-wringing over bonds suddenly matching the performance of equities should come a no real surprise. The negative correlation has been virtually continuous for 20 years, but they were consistently positively correlated for 20 years before that.
“If I did a poll and asked everyone what the correlation is between bonds and equities everyone would say negative, because of that 20-year period between 2000 and 2020 or so when bonds did their job,” he said, referring to the role of bonds as a diversifier that isn’t correlated to equities. “But they didn’t do that in 2022 and I’ll argue that they’re not going to have done it in 2023,” he said.
The reversion is not just a one-off, he argued, but actually “just reversion to correlation”.
“There’s a 20-year period from 1980 to 2000 where the correlation between bonds and equities was actually positive… and then you’ve got the roughly 20-year period to 2020, 2022. And what’s actually happening is that we’re now going back to that 1980 to 2000 period, we’re going back to when bonds and equities are going to have a positive correlation.”
There is a few tailwinds behind the cycle, he said, that should continue to maintain the returned positive correlation. The first of these is a decoupling of long-standing trade relationships, partly driven by the pandemic-induced realisation that large countries need to diversify their list of trading partners.
“The reliance America has in trading with China will continue to decrease, they’re going to open up different ports,” he said. “And that’s the same with lots of companies and countries around the world.”
Decarbonisation is another factor that should promulgate the new paradigm.
“Decarbonisation is not productivity positive,” he said. “It’s not like a mining boom. And that means it’s going to be productivity negative, which means somebody’s gonna pay for it.”
An ageing population and a proportionate decrease in working age adults will also be a factor, he explained, that will drive “higher inflation, higher interest rates, tight credit and volatility”.
The end result? Continued positive correlation between bonds and equities, which puts more wind in the sails of liquid alternatives.
Also speaking in the session, MAN GLG portfolio manager Edward Cole underscored what’s at stake for money managers, saying the next year or so is going to be “very, very dangerous”.
“There’s a great danger in having no diversification between your two main asset classes,” he said.
Liquid alternatives are a useful tool in the hunt for “risk parity”, Cole said, as it introduces a “cross-sectional, market-neutral strategy”.
“When we think about market neutral strategies, which is my day job, we’re looking for true diversified, mature, idiosyncratic strategies,” he said. “I think liquid alts’ are something that you will need to be thinking about in the macro sense… because the chances of high inflation being beaten in one go are pretty slim.”