Assessing the impact of high Inflation and rising Interest Rates to Multi-Asset Portfolio behavior
Makis Ioannou , CEO, Finvent Software Solutions
6 February 2023
In an environment of multi-decade high inflation rates and rapid monetary tightening paths by the world’s central banks, investors seek clarity on the probability and timing of a forthcoming economic recession.
The market sell-off that occurred in 2022 has been almost indiscriminate, with equities and bonds having suffered substantial price drops and capital outflows, at a time when market participants wondered where to allocate their elevated levels of cash in order to fight off the decaying effects of high inflation.
Although a large part of negative news may have been already discounted in asset prices, one cannot foresee with certainty when a turning point for asset valuations may be triggered, at the time that a normalizing pandemic supply shock seems to be met by a rather weakening consumer demand and a subsequent price discounting phase.
Proactively Reacting to Macro Fluctuations
This macro-economic environment cannot be viewed as surprising, as past investor surveys indicate that the majority of participants expect above-trend inflation to persist in the future, followed by a higher probability of a taper tantrum and spike in U.S. Treasury yields, as the Federal Reserve put the brakes on its QE program and rapidly raise interest rates.
We have often posed the question of whether Wealth/Asset Managers and Family Offices have been prepared to weather protracted unfavorable financial conditions, especially as high inflation proves to be much more than a transitory consequence of an elevated post-COVID consumer spending.
Ex ante portfolio modelling and stress-testing methodologies can help in this direction and include a wide range of risk factors against which a multi-asset, multi-currency portfolio can be stressed and revaluated at a user-defined frequency. Stress-testing algorithms can gauge a portfolio’s behavior in different market scenarios, such as higher interest rates occurring across short or longer maturities; this way one can manifest a data-based development of investment strategies by highlighting weaknesses or strengths in hypothetical adverse market movements.
Considering that history is full of instances where financial markets have reacted violently due to either policy decisions or to completely unexpected events, one can base the said analysis on a wide list of major historical events, or alternatively create custom scenarios that suit one’s intuition about the current market conditions and idiosyncratic characteristics of an investment strategy.
However, if a portfolio manager does not have a directional conviction about the prevailing market trajectory and concurrently observes that historical crises lack an adaptation to the present environment, a user can create a hybrid stress-testing model by amending various factors in a way that they better match the observable risk factor values.
Risk Modelling Flexibility
The factors that a user of a risk mitigation system can choose largely depend on the portfolio’s asset structure and instrument composition, and can include, among others:
- Interest Rates Term Structure, for portfolios with Fixed Income holdings
- FX Rates, for holdings denominated in currencies other than the base currency
- Index Rates, for portfolio holdings linked to an Index, such as Inflation Linked Bonds or Index-Tracking Funds
- Price Time Series, for portfolios composed of equity-like instruments, such as stocks and Exchange Traded Funds.
As long as the user of a portfolio risk engine can match a representative market index to a given macro factor (such as assigning a CPI benchmark to the inflation factor), one can run the analysis and assess the impact of macro factor changes on the portfolio, its adjusted Value at Risk and Market Value.
To facilitate such multi-factor analysis, the risk system estimates the correlation between the time series of the nominal interest rates that are affected by the increase in inflation projections and the time series of the portfolio holdings (such as equities, bonds, commodities, and alternatives) at any granularity (such as asset class, sector, credit rating, and geography level).
Such scenario simulations allow money managers to continuously customize the correlation among their portfolio holdings in a way that incorporates their prevailing investment views and alpha generation practices.
FINVENT Software Solutions is a provider of financial software applications and custom engineering services. The award-winning KlarityRisk platform specializes in investment risk analytics and fixed income performance attribution reporting, and it is offered to Private Wealth firms, Asset Managers, Hedge Fund Managers, Boutique Banks and Family Offices. All KlarityRisk solutions are already natively integrated with SS&C Advent APX.
Do you want to know more about our combined Portfolio and Risk Management solutions? Please contact us at email@example.com and we will get in touch.