Correlation conundrum: diversification in a strange environment
Serge Pizem, Global Head of Multi-Asset
Asset class correlations and volatility are widely discussed, but their relationship to each other is often overlooked. Serge Pizem explains why correlations matter, and how a well-constructed multi-asset portfolio can help in a period of rising volatility.
Investors could easily look back on 2017 with fondness, as most asset prices went up in linear fashion. Following the long rally across multiple asset classes, it may even have lulled investors into thinking that that was normal.
But 2017 was in fact an extreme outlier. ‘Last year was very special, in the sense that you had a complete collapse of realised volatility in US equities,’ says Serge Pizem, our Global Head of Multi-Asset.
‘I remember that at one stage 20-day realised volatility went below 5%, compared with the S&P 500’s long-term average volatility of around 15%.’ That meant volatility for US equities was almost as low as for US treasuries, which are considered a ‘safe haven’ asset.
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Pizem identifies three factors that caused this calm.
First, accommodative monetary policy compelled investors to buy equities and other risky assets because they could not earn anything in government bonds.
Second, investors supposed that they had a ‘put’ on central banks in developed markets. ‘In the minds of investors, the US Federal Reserve (Fed) will be there, the European Central Bank (ECB) will be there, the Bank of Japan will be there, and the Bank of England will be there to protect the markets if necessary,’ Pizem explains.
- And third, the volatility of fundamentals fell in 2017 – economic growth was robust and steady, while inflation rose modestly.
‘So that was a very conducive environment last year for risky assets and, by definition, a pretty poor environment for volatility,’ summarises Pizem.
The turbulence experienced in the market in 2018, then, may be less of a shock than a return to normality. February, of course, saw volatility spike to more than double its average levels of 2017 while US equities lost almost 10%.
‘What triggered this movement was actually some pretty strong numbers in the US jobs report,’ recalls Pizem. ‘The release was strong and prompted fears that we could see an instant acceleration in inflation that could lead the Fed to hike interest rates a little bit more than expected and end this Goldilocks environment.’
This fundamentals-driven volatility was also exacerbated by an unravelling of investors’ short positions on volatility. Many investors had bought into short volatility ETFs, betting that markets would remain tranquil. But these strategies struggled as turbulence mounted, and the algorithmic parameters of risk parity funds reinforced the sell-off, which added to overall volatility.
Yet, since that stormy month, markets have relaxed and resumed their upward trajectory as inflation has remained close to the Fed’s target and economic growth has proved resilient. Those are the positives, but investors should be mindful of the latent risks too and not become complacent.
What could drive volatility higher?
- The first of these risks is an escalating trade war. ‘If you look at the potential impact of what has been announced so far, it’s not massive in terms of global GDP,’ Pizem acknowledges. ‘But we have to look beyond these immediate first-order effects, to the second-order effect, which is the impact on confidence.’
For Pizem, the European debt crisis of 2012 is a cautionary tale in this regard. ‘You had this very negative feedback loop from the crisis on business and consumer confidence, so it’s difficult to estimate the end result on the global economy. We could be surprised to the downside, particularly as it seems that China doesn’t want to blink and is ready to endure some pain.’
- The second of these risks is the fact that Europe is still wrestling with its own domestic politics – not least in Italy where budget negotiations could force a credit downgrade. ‘Italy is just two notches above the high yield bond category,’ Pizem warns. ‘The market has already priced in a downgrade by one notch, which would still leave Italy with an investment grade rating, but anything more could create an absolutely massive shockwave. Among other things, the ECB wouldn’t be able to buy any more Italian bonds because its mandate only extends to investment grade debt.’
- Thirdly, there is the possibility that the US labour market continues to strengthen and wage growth accelerates, re-establishing anxiety about the Fed hiking too sharply. The US midterm elections may also revive volatility.
- Finally, on the technical side, stable financial conditions can set the stage for more dangerous speculation. ‘Volatility is currently very low and that could push some investors back into leveraged strategies, which could ultimately trigger more violent spikes in volatility,’ Pizem remarks.
Understanding volatility through correlations
As a multi-asset investor, all these risks are on Pizem’s mind. ‘Volatility and correlations are, of course, very important parameters when we manage portfolios,’ he says. ‘When you build a multi-asset portfolio, it needs to be well diversified in order to mitigate the impact of volatility in any one asset class on the rest of the portfolio. The idea is that when you have an asset class underperforming, you find another asset class that will compensate for that and cushion that underperformance through its own positive performance.’
Serge Pizem, Global Head of Multi-Asset
So how is Pizem preparing for what lies ahead? An essential step is being aware that equities and bonds are not guaranteed to be negatively correlated; during the taper tantrum of 2013 they notoriously lost money in tandem, as can be seen in the cross-asset correlation diagram, pictured below. ‘That’s where you need to find some alternatives in order to hedge your portfolios against these kinds of events,’ he advises.
Pizem highlights three current positions within his portfolios. One is to replace government bonds with inflation-linked bonds. ‘We think it is too early to reduce our exposure to growth assets like equities or high yield credit significantly, but at the same time we know that the monetary policy normalisation cycle could become a bit more aggressive,’ he elaborates. ‘Inflation-linked bonds can help mitigate volatility in such an environment by providing income and returns linked to inflation.’
Pizem characterises this as a medium-term stance, given that inflation and monetary policy operate on cycles closer to 24 months than three months. ‘That’s the reason why we have this long inflation-linked bond exposure, and also a short duration bias in our portfolio.’
The second is a realignment from European stocks towards domestic US equities. ‘To mitigate the potential impact of trade war and political risk in Europe, we have simply tweaked our equity allocation towards the US market,’ says Pizem. ‘The US is the most domestically oriented developed market, so it relies less on overseas earnings, and at the same time the strength of the US economy is clear and is translating into very strong earnings growth.’
Whereas companies in the US S&P 500 Index generate more than 70% of their revenues domestically1, European stocks depend more on exports and so could be harmed by higher tariffs.
Serge Pizem, Global Head of Multi-Asset
For Pizem, this is a short to medium-term view. ‘This is not something which is structural in nature,’ he outlines. ‘It is more linked to the risks surrounding Italy and the risks surrounding the global trade war. We know that European equities are much more exposed to global trade, so an escalation or even continuation could negatively impact the earnings of European companies over the short term. We don’t know when the Italian risks will start to recede and we don’t know exactly when the risk of a global trade war will start to recede, but we know that this is something that could trigger spikes in volatility and other adverse effects pretty quickly.’
Tackling correlations with multi-asset investing
Pizem has also hedged his dollar currency exposure. ‘We know that in an equity portfolio, for instance, currency volatility can be relatively strong and create unwanted risks,’ he says. ‘In order to mitigate the impact of this volatility in our total return funds, we have decided to hedge the currency exposure.’
This is a structural trend, in Pizem’s opinion, based on his outlook for the US dollar and the euro. ‘We think that the next big central bank to start to normalise its monetary policy will be the ECB, and that can create some volatility in the exchange rate,’ he believes. ‘We don’t want to be exposed to this volatility.’
These three positions get to the heart of Pizem’s approach to multi-asset portfolio construction. ‘You can break volatility down into two main elements,’ he sets out. ‘The first element is the volatility of your fund’s universe or your index. But that is in turn driven by the second element, the volatility of the underlying components of that universe or index.’
‘When we’re talking about the volatility of a multi-asset fund, a large part of that volatility is driven by the correlation between asset classes,’ Pizem concludes. ‘If the assets in your portfolio are highly correlated, then the volatility of your portfolio will tend to increase. Conversely, if you have assets in your portfolio that are not very correlated, you tend to limit the overall volatility of your fund because you have some assets that will outperform when others underperform and compensate for them. That’s very important, and that’s the concept of diversification. You don’t want to put all your eggs in the same basket; you need a cushion to limit the downside. That’s the name of the game when we talk about portfolio construction, and understanding correlation is absolutely key.
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