Correlation patterns between assets have not been behaving conventionally over the last month. Most notably, there have been periods when US Treasury yields have been rising (and their value falling) at the same time as equities have been selling off. Why have investors been abandoning safe-haven assets in the midst of the steepest market falls we have seen for 40 years?
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The answer lies in the flight to the ultimate safe haven: cash.
Firstly, the models that underpin certain investment processes, such as for risk-parity funds and some fixed income hedge funds, have broken down in the face of recent market falls. This has forced them to de-risk, sell assets and raise cash.
Secondly, many funds are having to raise cash to meet redemptions. In prevailing market conditions, where liquidity for some assets is so poor as to be non-existent, this means that investment managers sell what they can sell rather than what they would like to sell. Treasuries are the asset that allows them to facilitate these redemption requests. Indeed, even where they need to retain exposure to the underlying asset, one way of doing so is to sell the physical bond and raise cash, and then buy a swap which only requires a proportion of that cash as margin.
This positioning by fund managers has created a situation whereby liquidity drives pricing rather than fundamentals. While this presents challenges in the short term for conventional portfolio construction, it also provides opportunities for investors with a longer-term horizon and the willingness to take the other side of the trade.
The last couple of weeks have been characterised by exceptional stress in the markets. This has been reflected both in changes to cross-asset correlations and a drying up of liquidity in many of these assets. Even well-diversified portfolios have been challenged by these conditions, and the imperative is to look through the current volatility and try to avoid making major positioning changes.
Policymakers are stepping up to the mark with measures on an unprecedented scale, and there are tentative signs that price action is beginning to normalise. Although uncertainty will no doubt continue for some time yet, eventually correlation relationships will re-emerge, meaning principles of long-term portfolio construction remain sound.
