You asked, we answered: Gold's optimal portfolio weight in a higher correlated environment?

Reasons and consequences of a spike in bond-equity correlation 

Diversification across assets is important in the construction of resilient portfolios. And for many multi-asset investors, high-quality government bonds have been a reliable diversifier for equity risk - the two assets typically reacting differently to similar economic conditions. But this relationship appears to have broken down of late. In other words, the two asset classes are now the most correlated they have been since the mid-1990s (Chart 1).

It is the higher inflation environment which has, to a large extent, weakened the appeal of government bonds as a diversifier. At core inflation levels below 2.5%, the correlation between US equities and US treasuries has been, by and large, negative, providing diversification. At levels above 2.5%, this relationship has historically started to break down (Chart 2).

The lessons here are twofold:

• Investors need to be cautious of the risks of relying too heavily on historic correlations that are prone to change.
• The current positive correlation between bonds and equities undermines fixed income’s value proposition as a portfolio diversifier.

What is gold’s optimal weight in a positive bond/equity correlation environment?

The shift in the bond-equity correlation has presented many investors with a fundamental challenge around how to approach diversification and portfolio construction. In fact, amidst this rapidly evolving market backdrop, maintaining a diversified portfolio can feel like chasing a moving target.

Let us now illustrate how this change in correlation results in increased portfolio risk and how, in order to retain the same level of portfolio risk, the optimal allocation to gold needs to rise. Chart 3 outlines a simple hypothetical portfolio made up of three asset classes.  Using just three asset classes helps us isolate the impact from the change in correlations.¹

A mean variance optimisation analysis suggests that, generally speaking, a change in the bond-equity correlation environment from negative to positive results in a deterioration to the risk-adjusted returns by shifting the efficient frontier downwards (Chart 4).

In other words, all else equal, a portfolio’s risk profile rises as the correlation flips from negative to positive. Moreover, bonds become a meaningful contributor to total portfolio risk in such an environment (Chart 5).

And assuming that an investor’s risk tolerance remains the same, when the correlation flips from negative to positive, the optimal asset allocation should shift too, so as to remain in the pre-defined risk budget.

In fact, the ‘optimal’ amount of gold varies according to the bond-equity correlation environment. Broadly speaking, the analysis suggests that in a positive bond-equity correlation scenario, a larger allocation to gold is required to retain the initial level of portfolio risk (Chart 6).

Another way of looking at this is through the lens of a risk parity optimisation which seeks to achieve equal contributions to risk across various asset classes. As the correlation between bonds and equities rises so does their contribution to portfolio risk. In this scenario the optimal amount of gold again needs to rise to redistribute the risks equally (Chart 7).

Conclusion

The negative correlation between returns from stocks and from bonds – once the cornerstone of a balanced portfolio is in a state of flux due to the volatile inflation backdrop. In terms of the implications for diversifying investor portfolios, it remains unclear where the equity-bond correlation will settle. But recent changes in the macroeconomic landscape call for a cautious approach. For those investors that don’t hold gold, this might prompt them to broaden their sources of diversification. For those investors that already hold gold, it might mean increasing their allocation. Especially if approaching geopolitical risks materialise and bring stagflationary concerns to the fore once again.

Footnotes

¹While further analysis is required to determine the extent of gold’s increase in a broader portfolio, our previous research would suggest that is would result in a higher allocation due to gold’s effective diversification benefits across different environments.