February was another positive month for equity markets as they continued their upward trajectory, boosted by the Federal Reserve’s decision to place rate hikes on hold.
This article is intended for licensed financial advisers only and is not intended for use by retail investors.
February was another positive month for equity markets as they continued their upward trajectory, boosted by the Federal Reserve’s decision to place rate hikes on hold. But how long can markets remain placated? Despite the reprieve, key market risks remain, including a reduction in liquidity as central banks cease their quantitative easing programs, and tighter credit conditions, which have had a significant impact on those parts of the market supported by cheap debt and ample liquidity.
In uncertain market environments such as the one we find ourselves in, diversification becomes ever more critical to managing portfolio risk. Diversification across asset classes is key, but diversification across different investment strategies – such as absolute return and long-short equity strategies – is also essential.
There has been a lot of debate around whether bonds, which are traditionally seen as diversifiers to equities, can continue to deliver meaningful diversification benefits given the relatively low-yield world we are in. The chart below shows the rolling one-year correlation between global equities and global bonds. It shows that the correlation is not static: there are periods of negative correlation but also periods of significant positive correlation. Equity and bond correlations are influenced by a variety of factors. Rapid changes in real rates and inflation have tended to result in a positive correlation, an example being the ‘taper tantrum’ in 2013, which saw a surge in Treasury yields and a sell-off in equity markets. Conversely, growth shocks have tended to result in a negative correlation between equities and bonds as investors generally seek safe haven assets such as treasuries.
Equities and bonds are not always negatively correlated
Source: Lonsec, FE
Global equity returns based on the MSCI AC World ex Australia TR Index AUD. Global bond returns based on the Bloomberg Barclays Global Aggregate TR Index AUD Hedged.
So, do bonds still have a role to play in portfolio diversification? In our view bonds continue to play a key diversification role despite the low yield environment, and indeed we have seen bonds act as a diversifier to equities in recent periods where there has been a flight to safety. However, it is important to recognise that correlations between asset classes can change, and under certain conditions they may become correlated when you don’t want them to. This is why Lonsec’s managed portfolios are constructed to provide not only asset class diversification but diversification across a range of investment manager strategies and styles, which will perform differently as market conditions change. Given the current market uncertainty, this is an essential means of managing portfolio risks and delivering superior investment performance through the market cycle.
This article has been prepared for licensed financial advisers only. It is not intended for use by retail clients (as defined in the Corporations Act 2001) or any other persons. This information is directed to and prepared for Australian residents only. This information may constitute general advice. It has been prepared without taking account of an investor’s objectives, financial situation or needs and because of that an investor should, before acting on the advice, consider the appropriateness of the advice having regard to their personal objectives, financial situation and needs.