In 2018, almost all major asset class categories delivered negative returns:
So far in 2019, almost all major assets have done the opposite:
This degree of correlation is unusual. Some described last year as the worst on record in terms of correlated negative returns, while Q1 2019 has been referred to as “one of the most memorable” for the opposite reason.
While such correlated behaviour is unusual however, it should not be surprising. Since Dave Fishwick described a pivotal moment in markets in 2016, we have revisited the theme frequently (for example here and here).
And since at least Q4 2017, we have been highlighting the critical role played by US interest rate expectations (or ‘valuation risk’) in changing correlation patterns (most notably in February and October last year).
The tussle between rates and growth
Understanding recent market behaviour in this context provides an answer to those who would query why growth assets like equities have performed well in spite of materially negative earnings revisions, and macro data which has continued to disappoint:
Of course, we believe that it is always possible for assets to recover after the type of episodic moves we saw at the end of 2018, even without a fundamental ‘catalyst.’ However, it is hard to argue that developments in global interest rate expectations haven’t played a significant role this year.
The chart below shows US policy rates as implied by market pricing on the 20th December 2018 (just after rates were last increased) and today:
From expectations of modest rates increases, prices now imply an easing, which is supportive of global asset valuations. US bond yield declines have also been mirrored around the world: with German ten-year government bond yields turning negative in March, and yields in Australia and New Zealand reaching lower levels than they had in 2016:
Though we can argue about the extent of bad news that was already ‘priced in’ to growth assets, the removal of upward rate pressure on valuations has arguably been a more important driver of returns than any deteriorations in expectations for growth itself.
When this is the case we can expect heightened correlation across assets.
The return of diversification?
Can we say anything about whether this recent lack of diversification will persist? Prediction is dangerous but there are some observations worth making:
- Rate stabilisation?
Recent language from the Federal reserve is telling in that both short and long-run expectations for rates have declined:
Some would argue that the market has been telling you this for some time, but it is an attitude that now is mirrored in asset pricing after the uncertainty of 2018. If rates are structurally anchored (and the markets believe that this is the case), we could well see a re-emergence of government bonds playing the ‘safety role’ that they did for much of the last decade (albeit with a higher price to pay for that diversification outside of the US).
- Time horizon and context
It also matters what we are trying to diversify against, and over what time frames. In 2018 government bonds did not protect over the year as a whole, but they did in December. When it comes to growth shocks, that phase demonstrated that there is still a role for traditional safety asset to play.
However, we’d be wary of backing correlations to hold when the diversifying asset is unattractively valued. German and UK bonds did provide safety in December, but yields are now close to recent lows.
Moreover, even in the US, after the moves we have just seen, and the degree of consensus that appears to exist that rates will not rise, there could also be a near term vulnerability inherent in prevailing yields to any surprise on either inflation or growth.
- Other drivers of return
For all our focus on the issue, it also worth noting that rates are not the only factor that matter. Nor is it the case that government bond and other rate sensitive assets are the only sources of safety (though we would argue that many ‘alternatives’ are more rate sensitive than is often acknowledged).
It may be that at least some of the correlation in assets over the last twelve months is a result of coincidence rather than a shared cause and should not persist. For example, it is not obvious that the performance of commodities over the last year is directly related to rates. It may also be that equity performance, especially in Asia has been more directly related to progress in trade talks between the US and China than the rates dynamic.
There may be good reason to expect levels of correlation to be less extreme in future. This maybe true to an extent, but for the vast majority of major asset classes (including those labelled as ‘alternatives’) the potential for rates to act as a correlating force should not be dismissed.
- The role of idiosyncratic opportunities
A fruitful area for the episode approach in achieving diversification has been in identifying idiosyncratic episodes that impact specific regions or asset classes (such as those in Italy, Turkey, and Mexico last year). Such episodes often begin to move for reasons unrelated to the broader market.
In 2019 to date, such idiosyncratic opportunities have been few and far between. However, one rarely has to wait long for them to emerge and being in a position to respond can improve the prospective diversification properties of a portfolio.
It remains to be seen whether more normal levels of diversification will reassert themselves in the near future. However, the last year has shown the dangers of putting too much faith in diversification persisting, and in focusing on trying to control short term volatility at the expense of ultimate returns.
We can be more confident of diversification over the longer term when the fundamental drivers of return are different (we would expect UK property to be driven by different forces than Korean small cap companies for example), but shorter-term correlation patterns are far less predictable.
Investors who seek to manage portfolio volatility on the basis that certain assets will always offer safety, and who hold those assets even if they do not think they are attractive in their own right, will always be vulnerable to the types of shift in the environment we have just seen.