The Diversification Squeeze

Diversification from risk factor correlations in Axioma’s global multi-asset class model portfolio is at its lowest level since the portfolio’s inception in November 2016. During the so-called “Trump rally” after the US presidential election, the combination of rising stock markets, surging bond yields and an appreciating dollar led to a significant risk reduction from fixed income and non-USD assets. These relationships are, at present, almost reversed. Foreign exchange rate movements now amplify local stock returns in US dollar terms, further increasing the already strong correlation with the American market. Fears of higher inflation appear to have spooked stock and bond markets in the same way.

The chart below shows the most significant contributions from pairwise relationships of major risk types. We see that the negative interaction between equity and FX returns (against the USD)—indicated by the dark blue bars—has been an important source of risk reduction for most of last year. Another crucial diversifier was the inverse relationship of stock and bond price returns, highlighted by the lighter green bars. The combination of the two resulted in a healthy diversification benefit of up to 5.5% in mid-September, which is represented by the solid line on the right-hand scale.

With the exception of two short periods, the interplay of equity and fixed income assets was primarily driven by changes in risk appetite. In times of unrest, investors shifted their funds out of risky stocks and into safer government bonds, while good times for stock markets meant higher yields for bonds and, thus, lower prices. Only in July and November—when Federal Reserve Bank officials expressed their concerns about inflation being too “weak”—did share and bond prices move the same way. The prospect of slower price growth was good news for fixed income assets, while stocks still continued their bull run.

In a recent blog post, we noted that inflation—this time the “higher-than-expected” kind—is once more at the front of investors’ minds. As seen on the right-hand side of the chart, the light green equity/interest rate relationship once briefly contributed positively in the week ending Feb. 9, as inflation was—in our view not entirely fairly—blamed for the recent sell-offs in both the stock and bond markets.

The reversal of the FX/equity relationship started a bit earlier, around the turn of the year. For most of 2017, the correlation between global stock markets and the USD had been positive, driven by the expectation that the measures planned by the newly elected US administration—corporate tax cuts and infrastructure spending—would benefit primarily the US economy, which was good news for both stock markets and the dollar.

 

As we mentioned at the beginning, there is very little diversification to be had in our USD-denominated multi-asset class portfolio at the moment. However, the relationship between share and bond prices is already showing signs of reverting to the familiar pattern, as the stock market rebounded, while government bond yields climbed to levels last seen 4 years ago.

To see how the story continues and how changes in multi-asset class volatilities and correlations could affect your portfolio, we invite you to subscribe to our weekly Risk Monitor highlights email here.

Christoph Schon, CFA, CIPM

Christoph Schon is the Executive Director, Applied Research for EMEA at Axioma, where he generates insights into recent risk trends with a particular focus on fixed income and multi-asset class analysis. Christoph has been in the portfolio risk and performance analysis space for more than 10 years, having previously worked for Lehman Brothers/Barclays POINT and UBS Delta.