Measuring the Value of a Portfolio Liquidity Line
We provide CIOs with a framework to quantify the portfolio performance and liquidity consequences of using an external liquidity facility.
Noah Weisberger, Managing Director in PGIM Institutional Advisory and Solutions (IAS) group and Amanda White, director of institutional content at Conexus Financial talk returns in a volatile market.
A shift towards positive correlation between stocks and bonds is likely, and this phenomenon could persist for many years if history is a guide and this could lead to a “much more volatile world” for those trying to maintain balanced portfolios and may force investors to either raise their risk budgets or lower their return expectations, according to Dr Noah Weisberger, managing director at PGIM IAS group.
>> Welcome to Insights for Outcomes. I'm Julia Newbould, managing editor at Conexus Financial [inaudible] Investment Magazine. I'm joined today by Noah Weisberger, who is managing director in Institutional Advisory & Solutions Group at PGIM, the global investment management business of Prudential Financial. Noah has been at the IAS Group since January 2020. He began his career as a staff economist [inaudible] economic advisors and has 17 years on the sell-side of the industry, including at Sanford Bernstein & Goldman Sachs Global Investment Research. At PGIM IAS, he applies his microeconomic and policy expertise to the group's research and client advisory work with focuses on asset allocation and portfolio construction. The IAS team conducts [inaudible] quantitative client research that focuses on strategic asset allocation and portfolio and asset cost analysis across both public and private markets. Welcome to you Noah, how are things for you?
>> Thanks so much for having me, all is good here in the New York area hot summer.
>> So it's an interesting time now to be doing research on global economic conditions and the drivers of markets. And so I'm really interested in our discussion today where we're going to focus on stock bond correlations and the implications of your research for CIO's asset location decisions. You've done research looking at the drivers of stock bond correlations across global markets, but you began by looking at the U.S. back into 2021? So let's start there. We see that for the last 20 years or so, the correlation between stock and bond returns has been negative. So CIOs could increase equity's allocations with bonds acting as a hedge. Can you talk us through the findings of this initial research on the U.S. market with regards to the history of that stock bond correlation, why the correlation exists and what might be next?
>> Yeah, absolutely. And as you rightly point out 20 years is a long time in a career of most CIOs and most investors and market participants. Now all we've known collectively is negative correlation where stocks and bonds, as you say, hedge each other. But rolling the timeline back, you know, earlier in the post-war period, we've got 30 years from the mid-60's to 2000, a positive stock bond correlation and coming out of World War II, a period of once again, negative correlation. So what's really interesting about this marketing phenomena is that, you know, I think we're conditioned a little bit to think of things in a business cycle frequency perhaps or maybe even at higher frequencies, but this phenomena seems to last a really, really long time. So 30 years of positive stock bond correlation from the mid 60s to 2000 and 20 years of negative correlation. So whatever explanations you want to come up with it can't really be simple and unified. They're really going to have to operate on a number of different frequencies and levers. And if you just think about that long period of positive stock bond correlation, I mean, I think the sub-context years that we've been through 20 years of negative stock bond correlation what could be next? Well, I think what we're trying to tell people is what could be next is a period of positive stock bond correlation for some reasons I'll discuss in a moment. But if you think about the previous long, mid-60's to 2000 period of positive stock bond correlation, there is no simple "Oh, that was 30 years of x, y, and z." It was an oil price shock. It was a broker raising rates. And then, you know, rising inflation and then falling rates following inflation. It was Clinton's surpluses towards the end of that period. And then a tech bubble towards the very end of that period. So not very easy to classify that long period. And so what we've done is we've tried to link this long, slow moving stock bond correlation to macroeconomic factors and, in particular, of [inaudible] themselves relate back to kind of big elements of the policy environment. And so we think of the drivers of stock bond correlation for like the long term thematic as a function of fiscal sustainability issues, the degree of monetary independence, the degree of supply or demand, is driving the economic cycle and then a little bit about that [inaudible]. And what's interesting about these kind of policy and environment type framework is that it connects very naturally to what we think of as kind of the building blocks, [inaudible] statistical building blocks of stock bond correlation. So we [inaudible] start with stock prices and bond prices as being discounted sums of future cash flows to a very basic definition. And if you write that process out, we quickly come to, as an expression for stock bond correlation is that stock bond correlation is a function of the volatility of policy rates, the correlation of economic growth and policy rates and the correlation of equity and bond risk premium. And those naturally connect back to the degree of fiscal sustainability the degree of monetary policy independence, supply versus demand. We think those all have natural expressions in these more quantitative macroeconomic factors. And so if I were to think about what could come next, as we move into this negative period of negative stock bond correlation, I would say positive stock bond correlation is associated with worries about the sustainability of fiscal policy, less rules-based and less independent monetary policy or at least concerns thereof, supply side economic drivers and the tandem replacing a stock and bond risks [inaudible] sort of risks of tandem moving in investor sentiment towards those [inaudible] classes. And that would find expression as greater policy rate uncertainty, greater volatility straits, the negative co-movement between economic growth and policy rates and the positive co-movement of stock and bond risk price. So those are the things that we think have in the past driven stock bond correlation at least in the U.S. and [inaudible] going forward is what could push us into a positive regime from the negative one that we've become accustomed to.
>> So more recently, you took that research and applied it to global markets. Did you find the same sort of factors applied in terms of the drivers of the correlation in global markets?
>> Yes, so it's really interesting to me when we started to look at the global question. So we looked at the U.S. in conjunction with a handful of developed market economies. And so much like in the U.S., you take U.S stocks and U.S. bonds and look at that correlation over time. For any given, I don't know, the U.K., you could take U.K. bonds and U.K. stocks in pounds sterling and look at that correlation over time and Germany and so on. And what really struck me and kind of was counter to my own expectations was the degree to which [inaudible] stock bond correlations all moved together. And more importantly, for asset allocators and CIOs developed markets stock bond correlation regimes, is the stock bond correlation positive or is it negative seems really synchronized across the developed markets. And there doesn't seem to be any evidence that we can find that one country leads or lags systematically other countries, so there seems to be this simultaneous and joint determination of developed market stock bond correlation. Obviously, you know, they don't move [inaudible] there are periods of time where they differentiate themselves one from another. But to a first approximation it really, you know, very, very easy to see in the data that there seems to be a lot of coherence and synchronicity across adult market stock bond correlations. And so, you know, in some ways that kind of makes sense, right? It makes sense because if you look at stock returns and isolation, there's a very large global factor that drives stock returns across developed markets. And equivalently, if you just looked at sovereign bond return and isolation, there's a very large globe factor that drives bond returns. And so if stock returns are kind of global and bond returns are kind of global, it's natural to think that stock bond correlation is therefore global. But where the tension exists, I think, is that at least in my own kind of prior thinking about the global story was that U.S. story in our initial work seemed to be very much predicated on policy conditions in the local economy. And yet we have this really, really strong global force that seems to be driving, as I said before, kind of a simultaneous and synchronized movement in stock bond correlation across developed markets. So there's a little bit of an eye-opener [inaudible] relative to my own expectations. What we found initially in the very first look at the data, there's a lot more global coherence than I was anticipating, especially given my own priors that stock bond correlation was determined by, you know, physical policy sustainability, monetary policy independence, things that are very kind of local to the local economy.
>> It's nice to be challenged in your own research about your own predispositions, so that's a good outcome, Noah. So these 2 tensions that you've outlined, the global factors, the measuring fiscal policy, things like that and the local factors like the investor's behavior and investor sentiment driving the correlation. Can you unpack a little bit for us, the extent to how much each of these 2 factors are driving the correlations, you know, is it an equal kind of driver or what does that look like?
>> Yeah, absolutely, absolutely. So if the way the data kind of break in the statistical analysis, we tried to measure carefully global economic factors and economic policy variables. And to be very candid with you, we used the U.S. as our measure of global, so when I say global, I really kind of do mean U.S. in our analysis. And then we tried to extract the U.S.'s influence on local economic variables and just use that purely local leftover bit. So we looked at the impact of U.S. policy rate volatility, the correlation of U.S. economic growth and rates and the co-movement of U.S. risk premium alongside purely local versions of those 3 variables. And it sounds like a complicated process, but we came out with a very kind of neat and clean answer, which is that it seems to be that about 2/3 of a developed market stock bond correlation movement is due to U.S. factors and about 1/2 of the movement in an individual DM's, developed market's stock bond correlation is due to purely local economic drivers. And so, you know, like most things in life, the answer is never clean-cut and you see it's not like CIOs opt to pay attention just to the U.S.. And it's not like CIOs opt to pay attention just to what's going on in their local economy. They really [inaudible] pay attention to both local and global developments. That said, you know, I think that's a very clear result, this 2/3 global, 1/3 local. But in terms of the actual individual drivers, it's not quite black and white, it's a little more gray. But it seems like the U.S. economic factors that relate a little bit more to policy, so the volatility of interest rates, which probably has a lot to do with how predictable a rules-based monetary policy and how sustainable fiscal policy is and the co-movement of economic growth, U.S. economic growth and U.S. rates, which probably has to do with supply versus demand drivers, and probably has to do with the degree of rules that the monetary authority's following. Those 2 variables, the U.S. version seems to matter more, and the risk sentiment measure, that co-movement between equity and bond risk premium, the local version seems to matter a little bit more. So if I had to kind of dig in peel apart the onion like 1 layer deeper, you know, 2/3 global determination of local stock bond correlation mostly focused on U.S. policy risks, 1/2 local determination of local stock bond correlation, a little bit more about sentiment, the local sentiment rather than U.S. sentiment.
>> So if we kind of summarize then the most important factors in determining the stock bond correlations is volatility of policy rights in U.S. and local markets but more on the U.S. side, correlation between economic growth and interest rates and the co-movement between equity risk premium and bond risk premium. Can you give us a little bit more meat on the bone on each of dollars and expand on that for us?
>> Yeah, absolutely, and I'll go little bit out of order, to me, the co-movement between economic growth and interest rates is just an amazingly fascinating like summary statistic, if you will, for a lot of deep economic intuition. And I think to me, it captures what's driving the economy, you know, if you think back to an intermediate or introductory to economics class is that a shift in supply curve or shift in the demand curve is the monetary authority times supply is the economy with degree in which they're being overly easier, overly tight or is the monetary authority responding to the strength or the weakness of the overall economic environment. And so none of this, just as an aside, none of this is about the level of interest rates or the level of inflation. In our framework, it's all about the drivers of and the co-movements of it. I think there's a very, very important distinction. And so in a world where demand is driving the economy and so greater demand, pushed up prices, pushes up inflation, pushes up interest rates in a world in which growth starts to accelerates but then needs to raise rates in response, that's a world where you have positive correlation between economic growth and interest rates and a world where you have negative stock bond correlation and that, [inaudible] a little bit about the predictability of monetary policy. So think of the Fed, if they're following the Taylor rule, let's say, where they're concerned about unemployment and inflation, if they are independent of fiscal policy considerations, that's probably what you get. Secondarily, I would put the volatility of interest rates as pretty intuitive. And there [inaudible] we're concerned about the forward outlook and to the fiscal sustainability, the ability to maintain debt to GDP or you can pay down debt to GDP. And to the extent that we know what the policy is going to look like in the future because the monetary policy [inaudible] is predictable and acting in a rules-based way, that leads the muted policy rate volatility and probably to negative stock bond correlation. Conversely, if we're worried about the sustainability of fiscal policy, if we're worried about the independence of monetary policy and its supply shocks or a Fed that's behind the curve and trying to catch up, those are all kind of pushing in the positive stock bond correlation direction. And in terms of risk sentiment, I think that intuition is pretty, pretty clear, which is if we're replacing risks wholesale in the economy that would tend to move risk prices together. For instance, you know, in the current environment, you know, there's a little bit of a reverse [inaudible] story there too perhaps, which is if we realize that the policy factors are leaning towards a positive stock bond correlation, well then both bonds and stocks look a lot riskier than they have in the past. And so maybe we need to lower the price of those assets, increase the risk premium, and then the forward return will compensate you for that incremental risk. So when we're re-rating risks, that tends to induce positive correlation in risk premium and positive correlation in reinforce positive correlation in stock and bond returns themselves. But if we're talking about risk on/risk off, like if I'm selling my stocks, I'm buying my bonds. so I'm worried about something or [inaudible] and I sell my bonds and buy stocks, that's a negative stock bond correlation world. We think that that sentiment variable is a little bit more locally driven than it is globally or in U.S. [inaudible].
>> So we've talked a lot about the drivers of the correlation and you touched on it just a little bit there. I'm interested now in shifting the conversation to what it would take to actually see a shift in the stock bond correlation. So can you give us a little bit more about that? I know you just mentioned a little bit.
>> Yeah, absolutely. So, one thing to say as a caveat, in our formal research, what we looked at is a long-dated correlation measure. So it's 5 years. It's centered so it's somewhat backward looking and so you won't know for a while that is going to permanently, I'm sorry, is going to shift from negative to positive. But on a higher frequency basis, it does seem as if we're starting to get some evidence that stocks and bonds that have been moving in tandem for about the last 6-9 months maybe a little bit longer than that. [inaudible] you know, I think you can connect that back to some of the debates that are swirling currently, right? We have a lot of fiscal spending in the U.S. that's sort of heightening the concerns about physical sustainability. A lot of the conversation a year ago or 18 months ago, was about, you know, the balance between growth and interest rates [inaudible] sustainable pattern unsustainable one and then we spend more and maybe those risks become the balance of risk shifts there. There are certainly a lot of debate whether or not we're experiencing demand-driven inflation or there's supply side component to that and the supply side is driving things. It also looks a little bit different. And so those are some of the things that I think are [inaudible] swear on the radar screen. You know, we're not making forecasts here but we are trying to put on people's dashboards, if you will, the sorts of issues that they should be paying attention to, to evaluate stock bond correlation.
>> So I know you don't want to make predictions, but is it fair to say then that we, you know, given these findings are facing or about to face a different world in terms of the stock bond correlations?
>> I think there's an argument to be made that the risks are definitely, the balance of risk has shifted and I think the other message that we want to leave investors with is (A) as I said before, what would be the risk indicators or policy indicators that would make you start to think about this? [inaudible] second really important part of that conversation is what does that world look like, right? So how different is a positive stock bond correlation from an asset allocator [inaudible] positive stock bond correlation world for an asset allocator relative to a negative stock bond correlation world? So those are the 2 important components here. One, what should be on the radar screen for evaluating the balance of risk and two, what would that newer world look like should we find ourselves in a positive stock bond correlation world?
>> So we'll get to that in a minute in terms of what that would look like but sort of before we get to that, how do you think CIOs should be approaching this so, you know, assuming we are about to face or are facing a different world in terms of the correlations? How costly is it when we shift into that different correlation environment and how should CIOs be behaving, given that they don't know the future?
>> Right. I think one thing is important to bear in mind which is that this ends up being from the perspective of a balanced portfolio, a much more volatile world. And that means that [inaudible] extreme events are larger or more damaging. And some of the risk [inaudible] that used to be achievable, you know, a certain level of portfolio volatility or certain target [inaudible] ratio, they just may not be achievable when you don't have that extra buffer coming from negative correlation reducing volatility to the portfolio. You just don't have that anymore. And so we think that's a really important message. As for, you know, what actions can you take, you know, the risk is that you don't want to get over your skis in one direction or another. And so one of these, what we've been looking at, is can you, without being able to forecast correlation, should you assume it's always negative? Should you assume it's always positive? Or should you take a more [inaudible] approach and what would the damage be for each one of those approaches relative to the other ones.
>> And so if we do move into that positive correlation world, you've mentioned that investors should be aware that there's certain shock ratios or volatility levels that aren't achievable. In practical terms, does that mean, you know, re-looking at their return targets? Does it mean looking at different defensive assets? You know, what does it actually mean in terms of the allocations?
>> Yeah, so let me pick up on the second thing you said first then back to the first which is the inclusion of other assets in the portfolio. So we've looked at this a little bit. A couple of things, you know, we're talking, so the quest we're on when you frame the question that way is in a world where bonds are no longer a national hedge to stocks, is there another asset out there that we think would be, could be added to the portfolio replacing or, you know, filling out the portfolio to replace that hedging job that the bonds used to do. And then we've been, you know, the answer kind of is unfortunate. We don't really think that there's an asset that jumps out at us that really has the right characteristics and I'll kind of go through a couple [inaudible]. The first is if from a perspective of a U.S. investor of U.S. bonds [inaudible] hedge U.S. equities, would U.S. dollar developed market bonds be a hedge for U.S. stocks? In other words, if U.S. bonds don't do it, is there another developed market bond to put in a portfolio? And the answer, intuitively, I think from the way we would talk about things today, no. You know, developed market bonds look too similar for one to be a hedge when U.S. bonds are not. EM bonds also don't offer those hedging properties the way a U.S. bond would. And then of course, there's a commodity complex and a lot of the people looking at a commodity complex as an inflation hedge. But when you kind of condition on, when bonds are not a hedge to U.S. stocks, are commodities a reliable hedge for U.S. stocks? The answer kind of middling. On the one hand, yes, commodities are mildly negatively quarterly with U.S. stocks when U.S. bonds are not. So when you meet, when you don't have a bond hedge, maybe you have a modest edge from commodities. That said, commodities are at a much higher volatility than bonds, [inaudible] you really want to replace like a 7 [inaudible] asset to hedge your equity risk with a 20 or 30 [inaudible] asset when the degree of hedging is kind of moderate? So I don't know that there's an obvious asset to add to the portfolio to try to replace, to try to replace the bond hedge. You know, that said, I think really the heart of the issue is kind of what you said at the outset of that question which is, you know, how should you think about return target? How should you think about volatility targets and here's a trade off that, that investors are going to face. You can maintain your return target, but it's going to be achieved at a higher volatility. So if you have a risk manager and you have a firm ceiling, a firm volatility ceiling, you're bumping into that ceiling a lot more often in a positive correlation world than you would otherwise. And that can [inaudible] that risk management and the risk tolerance question. Alternatively, you know, and you may need to do that, if you need to achieve a certain return, it may be worth increasing the risk budget to do that. Alternatively, if the risk budget is really fixed and firm, you may need to accept a lower return in order to maintain that level of risk in the portfolio. So it's like the canonical risk reward trade-off, you know, how you respond [inaudible] your objectives and the purpose of those sorts of constraints on the investment process. But I think that's what we're trying to highlight to investors that if we go into a positive stock bond correlation world and do the planning now and do the thinking now, what's the set of reasonable outcomes to expect for this portfolio? What are the risks scenarios? Our draw-downs will be deeper. Tail events will be more damaging. Those sorts of things are going to be true and so how do you want to react in that kind of framework?
>> And you know, the evidence seems to suggest that, you know, whatever environment it is, a positive or negative, correlation persists for some time. Can we expect that if we do move into that positive correlation environment that it will be, you know, a decade or two rather than a short period of time?
>> [inaudible]. So I'm not sure how to answer that question with any degree of like certainty but we don't have no history, we have 50-50 plus years of U.S. history. And because of a deep irony [inaudible] correlations that it doesn't change until it does and then it persists. And so, you know, driving in the rear view mirror as they say, I think it a shift in correlation to positive [inaudible] would likely be persistent, and why would that be? It would be because it's mostly about, you know, how to invest [inaudible] expectations about policymaking and that's a really slow moving object. And so I would say that if we start to get evidence of a positive stock bond correlation, that's probably the world that we live in for some time. With that said, I've heard people argue that, you know, what seems to be persistent supply-driven inflation's really just [inaudible] the federal quickly, get back to a point where they are no longer perceived as being behind the curve but back to their rule-based mandate, if you will. And so maybe it's just a moment in time, but history suggests that these moments in time really do persist.
>> So the other reason you embarked on this research in the first place is to look at the assumptions that investors make and challenge those in terms of how they might change and whether those assumptions still hold true. What's next on the research agenda in terms of challenging investor assumptions and delving into that in some depth?
>> Yeah. So most immediately is to look at the optimal response to such a shift in correlation. You know, dig a little more deeper into other hedging options and think through as granularly as we can about what that would look like? What would an optimal portfolio look like for different classes of investors and, you know, how right you need to be about correlation to be comfortable to make that call, or maybe taking the agnostic approach as the data reveals itself is not too [inaudible]. So we're trying to calibrate some of those immediate, you know, continuation on the same things so there's immediate questions that follow up naturally as you've been asking [inaudible]. Then more broadly, I think that the stock bond correlation question kinds of fits in nicely with the broader research we do in the IAS group with a big focus, as you said at the very, very top of our conversation, on portfolio construction questions with both liquid and illiquid assets. So how does the interaction between a shift in correlation in the public part of your market, a public market part of your portfolio, perhaps interact with the decisions you would then need to make on the private side, especially in the context of the allocations we've seen and the shift in allocations we've seen on the private side. [inaudible] down nicely with other schemes of research that are ongoing at IAS, already ongoing at IAS.
>> So I think it's really important research for investors and for CIOs as they're looking to their asset allocation. Thank you so much for sharing it with us. It's been a pleasure speaking with you Noah, thank you so much for your time.
>> It's been my pleasure and thank you so much for your time as well.
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