An extended period of elevated cross-asset correlations has caught many by surprise. Diversification’s potency has been much reduced by central bank action, warns Anthony Rayner,manager of Miton’s multi asset fund range.
Is diversification dead? It’s a fair question. 2018 saw the vast majority of assets fall and, so far, 2019 has seen the vast majority of assets rise. To put some colour on this, Deutsche Bank analyse a broad range of risk-on and risk-off assets and in their sample (excluding currencies), 31 of the 38 assets made losses in local currency terms in 2018, while in the first half of 2019, 37 of the 38 assets made gains - silver being the only loser.
To be fair, these are randomly chosen time periods, even if it’s customary to start at the beginning of a calendar year, and within these periods, diversification was evident. For example, in Q4, US Treasuries rallied as equities fell sharply. Also, if a risk-off asset falls, say 1%, and a risk-on asset falls 20%, then there is some diversification to be claimed.
Nevertheless, there have been extended periods, such as last year, when risk-on and risk-off assets declined and when risk-off assets and risk-on assets gained, as seen so far this year. While we don’t expect correlations between assets to be fixed, as behaviours will always change over time, the extended period of elevated cross-asset correlations caught many by surprise, even if it seems obvious looking back. So, what’s been going on?
From a very top-down perspective, over the longer term, asset classes are sensitive to economic growth and/or inflation. This is expressed in financial markets through equity beta, credit risk and interest rate risk. Last year saw assets struggle due to weakening economic growth, including the impact of the trade war, and interest rate hikes, this year has seen assets benefit from more dovish central banks: rates were the common theme.
In short, tighter monetary policy hurt last year and an ‘about turn’ by banks at the beginning of this year led to assets rallying. This reminds us that interest rates determine valuations across assets. Over recent weeks, we’ve drilled into some of the less discussed non-equity asset classes available to multi-asset funds, including bonds, gold and property. One of the common conclusions was that interest rates are a key driver.
However, there are two elements that have exaggerated the impact of rates on financial markets over the last few months. One is that the change was a change in direction, from rates moving higher in 2018, to perceptions that rates are going to move lower in 2019. Perceptions that rates have peaked, or troughed, will understandably lead to more volatility than a simple rate change with no change in rate direction. Second, these days, rates can come with a ‘turbo-boost’ of QE or QT, and perceptions are that QT will be phased out later this year, compounding the effect of any rate cuts.
So where to from here? That may be best answered with another question. What’s the main factor to diversify against? It might well be that uncertainty around those key drivers, economic growth and interest rates, has increased and so exposure to lower for longer assets, such as long duration bonds, equity bond proxies and property, should be tempered, as should exposure to economically sensitive assets, like cyclical equity and high yield corporate bonds.
Across our portfolios we have trimmed our exposure to longer duration US Treasuries and gold, both of which have served us well, while we await better visibility on economic growth and interest rates, principally in the US. Turning to the question of diversification, it’s a stretch to claim its death, though its potency has been much reduced by central bank action.
Anthony Rayner is manager of Miton’s multi asset fund range.