One of the most important questions facing markets over the next 12 months is whether the US services sector can keep the broader US economy out of recession despite growing domestic and global manufacturing headwinds. If the US consumer remains resilient, this may in fact be a “mid cycle adjustment” (as Fed Chair Powell suggests) and a re-run of 2016/17, where a recovery in global growth sponsored renewed strength in global equities and a normalisation of bond yields. On the other hand, if the industrial downturn spills over to the broader US and global economy, we could see a prolonged period of global equity market weakness and much lower bond yields. 2000/01 was such an environment and one that shared a similar macro backdrop to today: strong US equity out-performance against the rest of the world, led by secular growth at the expense of value; a stronger broad US Dollar; headwinds across emerging markets. We’re at a fork in the road and our portfolios need to be able to handle either path the global economy takes.
From “bad news is good news” to “risk on/risk off”
Following the sharp equity sell-off and widening of credit spreads in Q4 of 2018 and the Fed’s dovish pivot, all financial assets tended to strengthen together during much of 2019 (albeit with trade and geopolitical headlines still driving a negative daily correlation between stocks and bonds). This has been an environment characterised by “bad news is good news” sentiment as soft economic data raised the likelihood of accommodative policy, but it also carried the implicit assumption that strength in key equity sectors would be dependent on multiple expansion from lower bond yields and a compression in credit spreads rather than improved earnings growth expectations.
With monetary easing having now resumed in much of the world, the question is less about whether we get further stimulus, but of whether the easing already undertaken and future easing priced in will be effective at prolonging the cycle further and sponsoring a recovery in the fundamentals of economic growth and corporate earnings. The implication of this is we transition from an environment that’s broadly supportive for all assets to a more “risk on/risk off” world, where risk assets and safe havens move in opposite directions in response to economic data and headlines. The other implication of this is correlations increase not just across equity markets, but between equities and credit, meaning only the traditional safe havens provide true volatility-reducing benefits for a portfolio within this environment.
When it’s crunch-time, correlations go towards +1 or -1.
Correlations between asset classes can vary significantly, both across economic regimes and within a business cycle. Furthermore, relationships may not be linear, and the direction government bond yields and credit spreads move may not just depend on the direction of the equity move, but the size of it. Causality can also be complicated, with strength in equities often driving bond yields higher as risk sentiment and growth expectations improve, but a meaningful move higher in bond yields can, in turn, negatively impact equities as financial conditions tighten, as was the case in October 2018.
However, in “risk on/risk off” environments, things become much simpler, with correlations bifurcating as equities, credit and carry currencies tend to trade in one direction, while sovereign debt, precious metals and funding currencies move in the opposite direction. Because true diversification is harder to achieve within risk assets, it’s important not to over-complicate asset allocation, and simplifying the universe into risk assets and safe havens may be a prudent framework to use over the medium term. Trying to reduce equity risk with regional, sector or factor tilts might not be so effective as equity beta is often sold indiscriminately in a true bear market or liquidity crunch. In addition, asset classes that ordinarily have low-to-moderate correlation with equities, like corporate and emerging market credit, securitised vehicles and sub-investment grade debt begin trading like equity proxies as liquidity, credit and equity risk are conflated as one and the same. In the post-GFC regulatory environment, dealers have far less ability to warehouse risk, giving credit exposures an asymmetric return profile where return volatility is skewed to the downside.
But government bond yields are at historical lows…
The performance of long-term government bonds over the past 12 months has been something to behold and the envy of even equity investors, with yields on much of the world’s sovereign debt now below levels previously thought possible. Indeed, it’s tempting to dismiss government bonds as an asset allocation building block and dramatically reduce their weight in asset allocations, but I believe this is misguided for several reasons.
Firstly, for long duration government bonds, yields matter far less for medium-term returns than how the macro environment evolves, and if we see further negative surprises to growth and inflation or geopolitical risks escalate, yields should continue their trend lower. Secondly, in the post-GFC regulatory regime, government bonds are less conventional assets for much of the world’s financial institutions as they are forms of liquidity insurance. High quality liquid assets (central bank reserves and government bonds) must be held by banks regardless of price, while institutions may themselves want to increase precautionary holdings of universally accepted repo collateral (such as Treasuries) in case unsecured interbank funding markets face pressures. Furthermore, liability-driven investors such as insurers and defined benefit pension funds can increasingly become forced buyers the lower long-term yields go to cover duration and convexity shortfalls. Finally, we cannot forget the role of central banks, which would be large-scale price-insensitive buyers of sovereign debt in any fresh round of asset purchases. With the last few months discrediting preconceived notions on where the nominal lower bound on long-term debt is, it’s honestly anyone’s guess how deeply negative they could go in a true crisis scenario. Precious metals should also remain well bid if macro conditions deteriorate, assuming they are seen to provide protection against competitive currency devaluation efforts, geopolitical risks and more experimental monetary policy and lower real yields.
Prepare for both upside and downside volatility
Despite heightened volatility and macro uncertainty, in my view it’s not necessarily the time to significantly reduce equities in case we see a sustained sequence of positive data surprises, which would likely sponsor a big unwinding of the recent winning trades (curve flatteners, precious metals, defensives and bond proxies) and a grab for the underperformers (US value, financials, EM and the trade-sensitive equity markets of Germany, Japan and South Korea). Because of this, broad global equities with a value tilt will likely be the biggest beneficiary from a re-emergence of reflation and globally synchronised growth, and it’s important for balanced portfolios to have such exposures to capitalise on the potential upside. However, if the bear case does materialise, and given the heightened liquidity vulnerabilities, it’s important that our defensive building blocks are truly able to offset equity drawdowns (by carrying enough effective rate duration and the highest credit quality) and we’re holding the types of assets that others are forced to buy when things go bad.
This article is general in nature and does not consider the circumstances of any individual. It is not a recommendation to make any investment or adopt any particular investment strategy. Future events and outcomes are inherently uncertain and may differ from those contemplated in any opinions given in this article.
Given the widespread overvaluation of the asset classes you discuss herein, investors can also look for real diversification to skilled dynamic management of their allocations and liquid alternative strategies. This can provide a return stream that is not prone to a sudden or massive devaluation risk, and one which doesn't rely entirely on a miraculous economic recovery or ever decreasing negative interest rates or government policy to keep its price elevated.