February saw inflation returning to the front of investors’ minds. A 0.3% rise in average hourly earnings, buried somewhere deep within last month’s US non-farm payroll report, was supposedly responsible for the worst weekly performance of the American stock market in nearly 2 years. Treasury yields also jumped to 4-year highs, buoyed by the anticipation of sooner and more aggressive action by the Federal Reserve Bank. At the same time, the dollar was bolstered by the prospect of higher short-term rates and a stronger outlook for the US economy. This triple whammy of falling share prices, rising bond yields and an appreciating dollar—combined with increased stock market volatility—led to a steep surge in the short-term risk of Axioma’s global multi-asset class portfolio and a pronounced reduction in diversification.
The 10-year US Treasury rate climbed to 2.95% on Feb. 21—a level not seen since January 2014—after the release of the Federal Reserve’s January meeting minutes, which stated that “a majority of participants noted that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate.” In the previous week, data released by the US Bureau of Labor Statistics had shown that consumer prices had risen by 2.1% in the 12 months to January—0.2% more than economists had predicted. In anticipation of even tighter monetary, short-term interest rate futures started to price in four hikes for the remainder of the year, compared with just three in previous projections.
On the other side of the Atlantic, things were less clear-cut. Members of the European Central Bank’s governing council were still considering whether to drop the “easing bias” from their official communication, whereas the Bank of England already seems to be set on increasing the base rate—potentially as early as May. Gilt yields rose in response, while the pound profited when the Bank upped its growth forecast for the UK economy on Feb. 9. Yet, gains were quickly wiped out, as fronts hardened on both sides of the Brexit negotiation table. As a result, short-horizon risk for GBP/USD jumped to over 9%, making sterling the most-risky currency of the developed world.
The prospect of higher Fed funds rates was also good news for the dollar, which appreciated 1.7% against a basket of major currencies in February. The yen was the only G10 currency that gained against the greenback, due the fact that Japanese investors tend to repatriate their money during times of high risk (see this blog post for more information). The combination of large equity downside risk and a stronger dollar made foreign stock market returns appear even more correlated with US share price movements, as local gains and losses were amplified by exchange rate variations. This is in stark contrast to what we observed in most of 2017—in particular during the “Trump rally” of the first quarter, when the equity bull run was accompanied by a strong dollar appreciation.
The negative interaction of share prices and foreign currency values had been an important source of diversification for Axioma’s global multi-asset class portfolio last year. The reversal of this relationship, combined with the increased market volatility and a near-zero correlation of stock and bond price returns, resulted in the portfolio’s highest total risk and lowest diversification effect since its inception in November 2016 (see chart below for weighted volatility contributions by risk type). The equity portion now accounts for 80% of total portfolio variation, compared with only half of the overall risk 12 months ago. Non-USD fixed income assets also saw their risk contributions increase due to the dominating exchange rate effect.
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