The chart of the year
In a development that could rain on the parade of bullishness that has enveloped global markets, the median correlation across nine types of global risk assets (including equities, credit and commodities) remains at levels beyond those seen during the global financial crisis and remains at hair-raising altitudes. Bonds ranging from US government to corporate high yield don’t produce very attractive returns at current interest rates. What’s more troubling is whether these asset classes can still offer diversification during periods of drawdowns in equities, which are showing persistently higher volatility than most previous years.
This high-correlation phenomenon is driven in part by the easing actions from the US Federal Reserve and other central banks spooked by the broad sell-offs earlier this year. A key question for investors is whether this activity will prove to be temporary or will mark a more lasting, structural shift.
For example, if we see ‘Japanification’, or low/negative yields persisting for decades in the US and Europe, then government bonds should play a defensive role in portfolios as the risk of persistently rising bond yields would be remote. In the case of Japan, shorting its government bonds became known as “the widow-maker” trade.
However, central banks may resist raising rates given record levels of debt and fiscal stimulus. If rates (and yields) don’t rise, there would be a limited negative impact on nominal performance; but investors would be worse off in real terms as the value of their assets would depreciate. In this scenario, inflation-linked bonds or inflation break-evens should offer some protection.
No one predicted a year like 2020. But combining assets with different triggers for defensiveness, such as moves in rates, liquidity and correlations, can help to increase overall portfolio resilience. Investors ignore the looming specter of rising cross-asset correlations at their own risk.
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Anthony Doyle is Head of Investment Strategy for the Firetrail S3 Global Opportunities Fund. His primary responsibilities include fundamental idea generation, portfolio analysis, and economic insights including currency and macroeconomic risk...