This year has all the characteristics to be remembered as an extra-ordinary year for financial markets. The return of inflation and uncertainty regarding the path of the economy ahead of us have created the perfect storm for most financial assets, writes Morningstar senior investment analyst Nicolo Bragazza.
Well-established relationships among assets have broken and many people have questioned the reliability of the 60/40 portfolio. Questions around the 60/40 portfolios might just be translated into the ‘loss of faith’ that the negative correlation between bonds and equities is a given and that, as a consequence, investors need to look for alternative sources of diversification.
However, 2022 has not reminded us that diversification sometimes does not work but rather that effective diversification is not about historical correlations and it is not just about equities and bonds.
Equities and bonds not always negatively correlated
Although history is important and may provide insights, historical correlations tend to be unstable and, even though there may be some relationships exhibiting more stability over time, it would be dangerous to imply that they cannot radically change even suddenly.
This is not to diminish the importance of diversification in multi-asset investing – it remains of vital importance – but rather to stress the idea that it is not a straightforward exercise and that requires more than simple historical relationships to be effective. In fact, investors need to have a deep understanding of the current macroeconomic and market environment coupled with the knowledge of the history that produced those correlations so that they can assess whether they are likely to hold in the future.
The idea that government bonds and equities are negatively correlated has been a distinct characteristic of the Great Moderation era, i.e. the last three decades characterised by stable inflation and higher predictability of monetary policy decisions, for example via the large use of forward guidance to guide investors’ expectations well into the future.
For the last three decades, market participants have been able to firmly rely on central banks to set the scene for these relationship to be stable through the reduction of the inflation risk premium and interest rate volatility.
Good diversifiers in 2022
In 2022, with the comeback of inflation and central banks struggling to get ahead of it, the most interesting observation to be made is that, even though it is true that some assets, most notably high quality government bonds, have not provided diversification, other assets have instead been good diversifiers and have been able to generate positive return notwithstanding equity markets falling the most since the beginning of the pandemic.
This confirms the idea that each scenario has its own diversifier and that investors have to assess which ones these are going to be.
It is the case of energy stocks, for example. Since the beginning of the year, energy stocks have been one of the few segments of the equity markets with significantly positive returns, even though energy companies tend to perform more negatively than most of the other sectors during usual equity sell-offs due to the link to commodity prices.
However, in a scenario of increasing inflation lead by commodity prices, energy stocks have proven to be a good diversifier and helped portfolios to achieve effective diversification.
Also, the US dollar has provided an interesting diversification benefit and, although the dollar has often been a good diversifier for UK investors in periods of market stress, this reminds us of the importance of not just focusing on bonds and equities to attain effective diversification: currencies should be an essential component of investors’ toolkit when it comes to diversification, although their risks should not be underestimated.
In this regard, the Japanese yen may provide a vivid example of a currency widely regarded as a safe heaven that this year has not worked, especially in the first months when inflation risk has caused investors to question the viability of the ultra-loose monetary policy of the Bank of Japan. That does not mean that the Japanese yen has lost its defensive properties, but that those properties are not given and in some scenarios may not materialize.
In investing, nothing is certain
If an investor wants to include an asset in the portfolio, it is essential to figure in which scenarios these diversifying properties are more likely to materialize to increase the likelihood of effective diversification.
In the fascinating world of investing, nothing is certain and this applies also to correlations. The duty of investors is to follow three simple steps to ensure they reduce the risk of being short of assets with diversification properties. Firstly, they should know how assets have behave in previous macroeconomic and market environments and why. Secondly, they need to prepare for different scenarios ahead. Thirdly, select the assets that may be most suitable to provide diversification in a range of these scenarios based on their intrinsic characteristics and current underlying economic exposures and not just based on history. In other words, as the future is uncertain, they need to diversify their diversifiers.
This article was written for Portfolio Adviser by Nicolo Bragazza, a senior investment analyst at Morningstar Investment Management