- Benefit of spreading risk across assets remains significant
- Rising equity/bond correlations could pose a significant challenge
Diversification remains the only free lunch available to investors, to paraphrase Harry Markowitz (the pioneer of Modern Portfolio Theory in the 1950s) but, like everything else these days, the portions on offer are smaller. Research published in the Credit Suisse Global Investment Returns Yearbook 2022 (Dimson, Marsh and Staunton) shows a general rise in positive correlations between global equity markets in crisis times over the past half century. That fact is highly prescient now Vladimir Putin has plunged the world into its most serious confrontation between nuclear powers since the 1962 Cuban Missile Crisis.
Investors must carry on and play the hands history is dealing, but that’s getting harder as recent stress episodes show. During bad times equity markets move more in step and investors relying on different geographies to spread risk saw radically higher spikes in correlations in the Global Financial Crisis and the Covid-19 sell-off compared to, say, the first Gulf War in the early 1990s.
Of course, you’d expect this where the event has been truly global in nature or panic has originated within markets (the October 1987 crash also saw a significant rise in correlations), but the research shows an upward trend in recent decades. Between 2001 and 2021, the average correlation coefficient in market moves for the UK, US, France, and Germany was 0.88, almost double the 0.47 observed between 1972 and 2000 and eight times the level between 1946 and 1971.
For US investors, the standout performance of their domestic stock markets meant no upside from buying overseas shares on either a currency hedged or unhedged basis up to 2021 whether from a starting point of 1974, 1980, 1990 or 2000. But for investors in other countries the figures imply casting the net beyond their home market is worthwhile. That doesn’t just mean buying US shares, the yearbook highlights that for investors in developed markets, emerging markets have provided excellent diversification benefits.
Change in the world order and de-globalisation
China has accounted for much of the rise in emerging markets and other countries have benefited from energy and soft commodity exports. But the current situation in Ukraine and its wider consequences should accelerate the rethink of globalisation that began with political events in the west (Brexit and Donald Trump’s tenure as US president) and became ever more pertinent due to supply chain vulnerabilities laid bare in the coronavirus pandemic.
Partly, that entails weaning Europe and North America off bad habits that enrich and embolden hostile regimes, which is not without cost. Reversing policies that have helped financial markets make easy gains in the last 30 years or so will hurt.
Low interest rates and easy money have been possible thanks to cheap imports keeping a lid on inflation. That must end if the US and its allies are serious about the long-term threat of China. Looking to spike the menace of Vladimir Putin, energy price inflation is painful collateral damage to be suffered if the west wants to prevent Russia’s president and his acolytes using their country’s wealth in oil and gas to fund aggression.
Dealing with inflation requires higher nominal interest rates and that means the remarkable returns from bonds (bond prices go up when rates go down) since the late 1980s are done. The Credit Suisse Yearbook shows that despite the high total returns for bonds and equities, the rolling 60-month average of correlations for the pattern of returns has often been negative in the era of low inflation, falling rates and easy money.
Yet this protection against the uncomfortable volatility of asset markets is not the norm historically. Pre-2000, the stock-bond correlation was positive most of the time, which can be put down to higher interest rates in years gone by. Tighter policy could see a return to positive stock/bond correlations, but investors still ought to diversify thanks to the haven properties of developed government bonds (and their currencies) cushioning share price falls in a crisis.
Going back to equities, the yearbook demonstrates rate tightening cycles are bad news for making excess returns over assets with no default risk like cash and quality government bonds. The chart shows all the UK equity premium has come in rate-easing cycles.
Things aren’t simple, though. Nominal interest rates will be held down as much as possible, in part to maintain currency liquidity in an era of financial warfare. There is still pressure for structurally low real interest rates, so shares remain worth owning as the equity premium can help out-run inflation in the long run. Holding government bonds too, to absorb shocks, should offer the best risk-adjusted returns. In other words, Markowitz’s free lunch is still out there, albeit not the feast it was.
