It’s the inflation, stupid! Um, isn’t it?

For most of 2017, we observed a negative relationship between stock and bond price returns. This resulted in a healthy diversification benefit in our global multi-asset class model portfolio. The only notable exceptions were two periods—one in the summer and one in November—when Federal Reserve Bank officials voiced concerns about persistently “weak” inflation. This was good news for bond investors, resulting in lower yields and higher prices, while equity markets continued their bull run, driven by the prospects of lower taxes and higher fiscal spending in the US.

Rising consumer prices were once again cited as the main reason underlying the recent market movements. This time, however, it was inflationary pressures from average hourly wage increases—rising at their fastest pace since 2009—that were identified as the culprit behind the stock market sell-off from Friday, Feb. 2. At the same time, we saw the 10-year US Treasury benchmark rate surge almost 20 basis points, breaking through the 2.80% mark for the first time in almost 4 years.

I’m not sure whether I completely buy into the inflation argument, though. For almost the entire 14 months since the Fed first hiked rates in December 2016, market commentators have stressed that rising consumer prices were a sign of a healthy economic recovery—a sentiment that was constantly echoed by central bankers on both sides of the Atlantic. It is human nature to look for an underlying reason that triggered a sell-off of such proportions—that is, after all, why so many ancient catastrophes were attributed, though questionably, to some mighty, supernatural being. The most important economic release on that Friday was the US payroll report, and the only even remotely bit of negative news was the slightly higher wage growth, which, of course, must have been the offender. Or maybe it was just the long-overdue correction? The fact that equity markets continued their recovery after Wednesday’s US inflation release—which came in slightly higher than expected—seems, at any rate, to confirm that last week’s turbulence may not just have been about consumer price growth after all.

Whatever the reason for the recent market turmoil, the effect on portfolio risk is undeniable. In the second week of February, short-term risk in Axioma’s global multi-asset class model portfolio almost doubled from 6.6% to over 13%. Most of this surge was, of course, driven by the sharp increase in share price volatility, but the newly positive relationship between stock and bond price returns also resulted in the lowest diversification benefit since the above-mentioned period in summer last year.

The graph below shows the effects of major risk factor volatilities and correlations on the model portfolio’s overall risk. The blue bars represent weighted standalone standard deviations for each risk type. If all risk factor returns were perfectly positively correlated, total portfolio risk would simply be the sum of these blue bars. If stock and bond prices had moved in absolute unison over the past 3 months, while foreign currencies would have had similar gains or losses against the USD, overall portfolio volatility would have been 15.5%. Yet, the green total bar reaches only just above 13%, indicating a diversification benefit of 2.5% (represented by the red bar) from less-than-perfect or even negative correlation.

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Christoph Schon, CFA, CIPM

Christoph Schon is the Executive Director, Applied Research for EMEA at Axioma, where he generates insights into recent risk trends with a particular focus on fixed income and multi-asset class analysis. Christoph has been in the portfolio risk and performance analysis space for more than 10 years, having previously worked for Lehman Brothers/Barclays POINT and UBS Delta.