Since late 2017, we have observed the critical role played by expectations for US interest rates in shaping correlation patterns. Rates of interest in the world’s largest economy are an all-important benchmark for investors to value other assets.
After all, if you expect to receive 3% a year in so-called ‘risk-free’ returns in the US, let’s say, why would you accept the same prospective returns from higher risk assets like company shares? We would instead expect the latter’s price to fall to a level where the extra returns on offer tally with the additional investment risk involved.
There has been an important reversal in US interest rate forecasts over the past few months. Rather than being expected to continue slowly rising, to 2.5% over the next year, the prevailing view among investors at the start of April 2019 was that they would fall back to around 2%.
With lower rates of interest anticipated from US risk-free assets, it has lifted the lid for asset prices across the board to rise – from government bonds to company shares. This being the case, it is hard to argue that changing US interest rate expectations haven’t contributed to recent correlations in market movements.
How long can this carry on?
Making predictions is always dangerous, but there are a number of reasons why we might expect recent correlations in asset prices to come to an end.
Recent guidance from the Federal Reserve, the US central bank, indicates that both short and long-run expectations for US interest rates have declined. If rates are structurally anchored at current levels, there will be fewer movements to drive global asset prices one way or the other.
Assuming US interest rates remain relatively static, we could well see a re-emergence of government bonds playing the role of perceived safety that they did for much of the last decade.
Indeed, German and UK government bonds performed well in December 2018 while global stockmarkets fell sharply. There is, however, a high price to pay for that diversification, at least outside of the US, as government bond yields in Europe and Japan remain close to historic lows.
While we should be wary of dismissing the correlating force of interest rates, it’s worth remembering that they are not the only factor that matters. It is not obvious, for example, that the performance of commodities, like gold and oil, over the last year has been related to rates.
Instead, the correlation in asset prices over the past year or so may be largely the result of coincidence. Stockmarket performance, especially in Asia, has arguably been more directly related to progress in the US-China trade dispute than to US interest rates.
It remains to be seen whether more normal levels of diversification will reassert themselves in the near future. However, the last year has shown the dangers of putting too much faith in diversification persisting, and in trying to control short-term volatility at the expense of returns.
Shorter-term correlation patterns may be unpredictable, but we can be more confident of diversification over the longer term when the fundamental drivers of asset returns differ. For instance, we would expect UK property prices to be driven by different forces than the prices of South Korean small companies’ shares.
Investors who seek to manage portfolio volatility on the basis that certain assets will always offer safety, and who hold those assets even if they do not think they are attractive in their own right, will always be vulnerable to the types of shift in the environment we have recently seen.
More effective diversification can be achieved by identifying idiosyncratic episodes, where asset prices are moved away from their fundamental value by irrational investor behaviour, that relate to specific regions or asset classes. Such episodes are typically unrelated to the broader market.
Opportunities like this have been few and far between so far in 2019. However, one rarely has to wait long for them to emerge.
The views expressed by the author should not be taken as a recommendation, advice or forecast.
Neither past performance nor the current situation are guides to future performance.The value and income from the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.