Economist Harry Markowitz is credited with coining the phrase “diversification is the only free lunch in investing”. What this really means is that by combining asset classes and strategies with a positive expected return, but which zig and zag at different times, we can reduce the overall volatility of the journey and improve the risk-adjusted returns.
Correlation is a measure of the strength of relationship between different variables so it follows that if a portfolio is to be diversified it needs to contain securities with a low correlation to each other. Yet correlations do not always behave as expected, meaning investors need to have a broader consideration of what might impact them.
Large numbers alone do not necessarily equate with diversification. For example, a global bond index such as the Bloomberg Barclays Global Aggregate Index, which is invested in different types of fixed income around the world, comprises nearly 23,000 individual bonds (as at 31 March 2019). However, its very construction means the largest debtors have the largest weights in the index and its compositional drift reflects the past, rather than what is necessarily relevant for the future. As a result, the dominant risk factor is interest rate risk stemming from moves in underlying government bond yields.
We have come to expect government bonds and equities to be negatively correlated ie, when one moves up, the other moves down, and vice versa. This is typically true because earnings primarily drive equity prices and interest rates primarily drive bond prices.
When economic conditions are deteriorating, central banks tend to lower interest rates and bond prices go up but equities still reflect the weak conditions for earnings. Yet as we move into recovery stage, equities begin to respond positively to the lower interest rates. In contrast, when the economy and earnings are strong, equities do well and central banks typically raise rates to try and prevent the economy overheating. This usually hurts bonds first, since they are directly sensitive to the changes in rates but at some point it begins to hurt equities too as markets price in expectations of an economic slowdown.
However, the correlation ultimately depends upon both the inflation environment and the volatility regime. So in understanding the changing nature of correlation, it helps to think about different economic scenarios.
For example, the negative correlation between government bonds and equities that has presided over the last 25 years tends to break down at times of shock. We saw this in 2013 with the taper tantrum real rate shock and again in early 2018 when there was an inflation shock. On both occasions, investors demanded higher yields on US government bonds, which caused bond prices to fall, yet at the same time the equity market tumbled (spooked by potentially higher financing costs). This environment resulted in rising rates and wider credit spreads which acts as a double whammy to a fixed income portfolio.
The taper tantrum was caused by a congressional speech by Fed Chairman Ben Bernanke in May 2013, in which he suggested that the US Federal Reserve (Fed) could begin tapering its asset purchases. This led to the markets mispricing the Fed’s intentions towards its accommodative interest rate stance and assuming higher rates were nearer. Bond prices and equity prices both fell (positive correlation) on concerns about potentially higher rates, although negative correlation resumed later in the year.
Correlation of 7-10 year US Treasury with S&P 500 Equity Index during taper tantrum
Source: Thomson Reuters Datastream, Janus Henderson Investors, S&P 500 Total Return Index, ICE BofAML 7-10 year US Treasury Total Return Index. Three month moving average of one month correlation using daily returns in US dollars. Moving average is centred to be more coincident with events.
Why should a fixed income portfolio manager care about equities or other asset classes? First, because capital markets do not exist in isolation. Strong equity markets make equity financing easier, potentially increasing the equity weighting in the debt/equity ratio of a company. This is important as we move down the credit spectrum where lower-grade corporate bonds are more sensitive to corporate conditions.
Second, policymakers care about markets so we need to pay attention to other markets. For example, between 1987 and 2006 Alan Greenspan as Fed Chairman set a precedent that the Fed would intervene to support the economy (and by extension markets) in times of crisis. More recently, following the equity market sell-off in late 2018, we saw the Fed in early January 2019 backpedal on its intention to raise rates several times this year.
Correlation and diversification
It might seem that a fixed income portfolio – being focused on one asset class – would struggle to generate diversification but this belies the diverse nature of the asset class. If we look under the bonnet, many sub-sectors of the fixed income market often perform differently over the same period; for example, floating rate notes or index-linked bonds – where coupons rise with rising interest or inflation rates – perform differently to fixed rate bonds. Similarly, divergence can occur between different countries: in 2018, holders of Australian government debt achieved a 5.3% return in local currency terms, whereas Italian government bond holders suffered a 1.4% fall.*
*Source: Thomson Reuters Datastream, 31 December 2017 to 31 December 2018, ICE BofAML Australia Government Index, ICE BofAML Italy Government Index, total return in local currencies.
Having the freedom to move between different geographies allows an unconstrained investor the opportunity to take advantage of differences in the yield curves between countries. The chart below demonstrates how, over just two years, yield curves can move in very different directions. The US yield curve has flattened as the US has pursued monetary tightening, while the yield curves in the eurozone have remained steep, reflecting negative rates. Meanwhile, in New Zealand, rates have fallen significantly from levels that reflected an over-optimistic assessment of the economy.
Sovereign yield curves, same period but different outcome
Source: Bloomberg, country sovereign curves, euro swap used as eurozone proxy, as at 31 March 2017 and 31 March 2019. Yields may vary and are not guaranteed.
Gauging where a country might be in its economic and credit cycle therefore has important implications for where we might want to be invested in terms of accepting or avoiding interest rate risk or credit risk. Broader cycles incorporate mini cycles, so there are periods when yields may temporarily rise or fall, or credit spreads widen or narrow, independently of what might be expected of the cycle. Often this is triggered by shocks, including unexpected economic data, politics, policy surprise by central banks, or idiosyncrasies associated with an issuer. An active approach allows active managers to tactically exploit situations as they arise.
Overall, a global approach allows us to maximise opportunities for diversification and seek securities and strategies with low correlation to each other. Portfolio construction is a critical element to ensure these are carefully blended together and to manage our exposure to scenarios that may cause correlations to change.