Blog Posts — April 26, 2018

How a looming trade war is reversing multi-asset correlations

by Christoph Schon, CFA, CIPM

The first quarter of 2018 was characterized by the dramatic return of share price volatility. At the start of February, strong wage rises in the US revived concerns over rising consumer price inflation, triggering a simultaneous sell-off at the stock and bond markets. This had a strong adverse effect on multi-asset class risk. More recently, however, worries about a potential trade war between two of the world’s biggest economies led investors to reallocate funds from risky equities to the relative security of government bonds and safe-haven currencies, thus returning to the more familiar patterns observed over most of 2017.

During the so-called “Trump rally”, following the US presidential election in November 2016, accelerating inflationary pressures were seen as a sign of healthy economic recovery, which was underpinned by bullish assessments from central bank officials on both sides of the Atlantic. Rising short-term rates in the United States supported both the USD and the stock market, while long-term interest rates also increased. The ensuing negative relationship between US equities on the one side, and non-USD denominated securities and fixed income assets on the other, resulted in a significant risk reduction in Axioma’s global multi-asset class model portfolio during most of last year.

Two major exceptions were July and November, when Fed meeting minutes revealed growing concerns among rate-setting committee members about consumer price growth being too weak. The lower inflation expectations led to higher bond valuations, while share prices still continued to go up, resulting in a temporary co-movement of these two asset classes. This entailed a significant reduction in portfolio diversification, aggravated by a reversal of the FX/equity correlation in July.

The perception of inflation seemed to change abruptly at the beginning of February, however, when an above-consensus rise in average hourly earnings was blamed for the sharp stock market correction. This again led to a positive interaction between share and bond prices, which now both fell. At the same time, the dollar was lifted by the prospect of higher short-term rates, as the central bank was expected to tackle consumer price growth more aggressively. Previously, the dollar had weakened, when stock markets were still heading north, which meant that foreign-currency gains had already been positively related with equity returns since December. The ensuing squeeze in diversification—combined with the steep surge in stock market volatility—resulted in a marked increase in portfolio risk.

More recently, fears of a trade war with China and escalating tensions in Syria once again let investors flee from the stock market, this time moving their money to the relative safety of government bonds. The dollar also depreciated as risk appetites decreased—benefiting mostly the Japanese yen and the Swiss franc. From a risk perspective, this meant that fixed income assets and non-USD denominated securities once more provided diversification benefits versus US equities, thus significantly reducing overall portfolio volatility.

It is hard to predict where multi-asset class correlations are heading in the near term. Inflation certainly seems to be a major driver—one way or the other. When consumer price growth releases come in above expectations, stock and bond prices fall in unison, and the respective currency rises on the expectation of sooner and more aggressive rate hikes. Vice versa, weaker readings tended to result in higher valuations for both equity and fixed income securities. Speculation on short-term interest rates also seemed to have been a driving force behind the EUR and GBP exchange rates against the USD. The values of safe-haven currencies JPY and CHF, on the other hand, were more determined by the degree of risk appetite in the market.

Presently, multi-asset class correlations seemed to have reverted to the patterns observed over most of 2017. However, once the specter of rising inflation rears its scary face again, things might tip over relatively quickly and portfolio diversification could be squeezed once more. To follow 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.