The recovery of inflation as a significant issue in 2022. triggered heavy losses in both bond and equity markets, and although it has since fallen from its highs, Gopi Karunakaran believes inflation uncertainty remains high and could see mid-2022 revenge.

Speaking to InvestorDaily, the chief investment officer at Ardea Investment Management said there are realistic forecast scenarios where inflation stops falling – or indeed starts to rise again – which would be negative for both equity and bond markets.

“Increased inflation uncertainty has changed the bond/equity correlation, making it more volatile and more often positively correlated. As inflation uncertainty is likely to remain for some time, we can characterize this changing correlation behavior as a regime shift rather than a simple temporary hiatus,” he said.

According to Karunakaran, this regime change affects the traditional role of long-term government bonds as a safe asset, as it makes bonds less reliable and less effective as a protective diversifier of capital risk.

“Bonds play their role as safe havens most effectively when they have both low volatility and low correlation to stocks. The regime shift to a more uncertain inflation environment has made bonds more volatile and made the bond/equity ratio more volatile,” he said.

However, that does not mean long-term government bonds are no longer useful as a diversifier, Karunakaran said, noting that they can still be useful in certain scenarios, including an economic growth shock.

But given that the reverse is also true, he stressed that "simply relying on long-term government bonds as the sole diversifier for equity risk is not a good idea."

"The key takeaway is that portfolio construction should not over-rely on long-term government bonds as a protective diversifier for equity risk," Karunakaran said.

“Relying on just a single duration lever to diversify equity risk involves an implicit macro prediction of what types of macro scenarios are likely to play out going forward. this [is] a risky bet given how unreliable macro forecasts are in general, and especially in regimes of heightened inflation uncertainty.”

An alternative approach, he noted, is to reduce reliance on macro forecasting, focusing instead on building portfolios that are resilient to a wide range of possible outcomes.

"This means expanding the risk diversification toolbox to complement conventional duration leverage with other investments that exhibit the following characteristics: low downside volatility, low equity market correlation, strong defensive bias to outperform when equity (and bond) markets suffer losses, attractive standalone risk versus return profile (positive expected return from true alpha),” Karunakaran said.

Highlighting "behavioral consistency" as key, he added: "It doesn't make sense to have a risk diversifier in a portfolio that exhibits these qualities in good times but becomes equity-like in bad times."

“It's like an umbrella that only opens on sunny days… it's not fit for purpose.

"Reliable risk diversification comes from adding investments whose primary return drivers are truly different from the factors that drive capital returns, especially in extreme scenarios."

But Karunakaran warned investors to be wary of investments labeled "alternatives" as well, noting that while some may look "quite different" from stocks on the surface, they can actually behave like stocks when markets fall.

"Therefore, it is important to look beyond the labels and understand the actual underlying drivers of investment returns and how those drivers are likely to affect performance under different share market scenarios."