In a report Friday, SG said expected returns had improved due to a reduction in volatility and cross-asset correlation. The correlation between bonds and FX, as well as equity and bond prices have all declined recently, the bank said.
However, correlation between equity markets remains near its peak meaning there are limited benefits to diversifying by investing across equity markets, SG said. This is particularly problematic when you consider that equities have witnessed improved expected return over the past three months.
To combat this, SG advised going underweight equities generally, but weighting more toward Europe-ex-UK equities within the allocation.
While Europe-ex-UK equity exhibits marginally higher volatility, due to lower correlation with other asset classes, stated SG, it provides a better diversification opportunity, thereby reducing portfolio volatility.
Reallocation from government bonds to inflation linkers and corporate credit will also help to reduce volatility, according to SG. Because “the efficient frontier has moved up, indicating an improving risk-adjusted return environment,” SG suggested portfolio managers are more likely to be rewarded from inflation of bonds than from government bonds, especially with the pace of Fed rate hikes being re-priced.
Although, SG’s Q-Map model confirms that “linkers are great diversifiers”, it also warned that greater diversification could potentially result in lower returns.
“The risk-averse portfolio has less allocation to government bonds and more to inflation-linked bonds, corporate credit and cash,” the report concluded.