In such volatile times, the road to recovery is one that must be watched closely, as flexibility to adapt to potential changes can prove vital.
One of the first pieces of advice investors are given is the importance of having a diversified portfolio. The rationale is that if the returns on your assets are subject to different drivers, then weakness in one asset should not necessarily be reflected in weakness across the whole portfolio. The most important contributor to the diversification effect of an asset is the correlation to the rest of the portfolio: the lower the correlation, the more diversifying the asset.
Experience tells us correlations change over time, but over the last few years we have seen a sharp increase in the correlation between the sorts of risk assets to which investors look for returns. The diversifying effect of, say, commodities against stocks has fallen as the correlation between the two has risen. We have seen that pattern repeated among many of the asset classes, to a point where correlations are as high as I have ever seen them. This is challenging for investors, because as correlations rise and portfolios become less diversified, this lessens their ability to weather corrections such as we saw in 2008.
Understanding the reasons
There are a number of reasons why correlations have risen, and if we can understand those, it should help us understand how the environment for investing will unfold as we move forward.
From 1990 to 2007, we saw much lower-than-normal economic volatility, the peaks and troughs in activity were much lower than we had seen in the previous 20 years, and indeed economists have dubbed this period “The Great Moderation”. When the economic cycle is muted, the cyclical nature of asset classes is not so pronounced, and the different fundamentals that drive stocks, real estate, commodities, currencies and so on, shine through. When economic volatility picks up, it is the cycle that becomes the fundamental driver to returns.
When economic activity drops sharply, as it did in 2008, the outlook for profits deteriorates, making stocks much less attractive. The demand for raw materials also falls, which depresses the prices of industrial commodities. The economic weakness calls into question the ability of companies to service their debt, which causes the spread of credit over government bonds to widen, and so we see a sell-off in credit markets, particularly in high yield. Real estate is affected because the ability of tenants to continue to pay rent is uncertain amid the economic weakness. In a more muted cycle, these events do not tend to happen in such a compressed time-scale, or to the same degree.
Catalyst
A second factor is it was probably the lack of correlation that started the process in the first place. If we looked at the investment landscape 10 years ago, there were a number of areas where we could see assets that offered an attractive combination of higher returns with relatively low correlations between them. As money sought out those asset classes, particularly when backed by leverage, this had the effect of bidding up the prices of those assets in line with the strong equity market returns we saw between 2003 and late 2007.
A related effect is the willingness or ability for market participants to accept investment risk at times of market volatility. Private investors may be concerned about the increased uncertainty and reduce their exposure to risk assets, at the same time institutions such as insurance companies or pension funds may be compelled by regulation to reduce risk as markets fall. In 2008, leverage was withdrawn from the system causing hedge funds and prop desks to unwind exposures.
Taken together, this can create a wave of selling pressure with no-one to take up the opposite side of the trade, until very low prices encourage bottom fishing. This phenomenon is not restricted to sell-offs. In 2009, as the outlook improved and investors came back into markets, the relatively low liquidity meant that all risk assets rose together, maintaining the high levels of correlation.
Flight to safety
In the current environment, there is one area of diversification that should not be overlooked. There is a sharp contrast between the correlated behaviour of risk assets and the strong negative correlation between risk assets and what we call “flight-to-safety assets” such as cash and high-quality government bonds. While these assets offer little in the way of return at current levels, they do offer strong diversification benefits in these times of uncertainty.
The key question is whether this state of affairs can continue. Wherever we look, correlations among risk assets are very high, and so it is hard for us to see them rise further from this juncture. We would expect to see some unwinding, particularly in areas where investors feel non-core assets have failed in their diversification role, and wish to refocus around more traditional portfolios. While the direction seems quite clear, the timing is very difficult: we know markets can remain at extremes for much longer than people expect.
Outlook
So where does this leave us? On the one hand, we need to deal with the current situation where correlations among risk assets are high, yet we can exploit the strongly diversifying effects of flight-to-safety assets. On the other hand, we recognise at some point liquidity will return to the markets and investors will rebalance their portfolios, and if this is accompanied by a more dependable economic and market outlook, correlations should fall and diversification among risk assets should rise once more.
This is going to be a tricky road to navigate, probably requiring some astute tactical calls along the way. We will be watching the economic data and market behaviour in order to help us. For those investors or advisers with other calls on their time, the use of a good multi-asset fund with the flexibility to adapt to the changes may prove helpful.
Richard Skelt, co-head of investment solutions group, Fidelity
