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Strong correlations since the financial crisis will begin to break down
Keeping global monetary policy so loose for years was a necessary response to the global financial crisis. While such policies helped stabilise financial markets and economies, they have also made many investors too complacent.
As central banks prepare to retreat from the purchase programmes that have seen trillions of dollars pumped into world markets since 2008, and look at hiking rather than cutting interest rates, asset prices should once again be driven by fundamentals. Highly correlated returns across asset classes, courtesy of the flood of liquidity by central banks, can no longer be taken for granted.
Key questions need to be addressed as central banks step back. Will the new environment snap back to pre-crisis dynamics? Will investors find themselves in uncharted territory? And, as the correlations between asset classes change, where will the opportunities created by the new dispersions occur?
With close oversight and more demanding capital requirements having replaced light touch regulation, a widespread return to the largesse that helped trigger the crisis is unlikely. Rather, the “risk-on, risk-off” dynamic that has been a significant driver of markets for almost a decade, has already started to break down. Correlations rose only briefly after the periods of turmoil that followed the UK vote on membership of the European Union and the US presidential election.
Wider dispersion of returns means a return to nuance for investors, which brings with it challenges and opportunities. Reliance on pure equity beta and falling interest rates is no longer enough. Investors will need to be more conscientious in their evaluation of the state and trajectory of the global economy, as well as valuations across asset classes. This is the discipline that will define success in the new environment.
The process of normalisation is due in part to a gradual rise in neutral real interest rates — a concept that describes where central bank rates should be if policy is neither expansionary nor contracting for an economy. These rates were deeply negative during the financial crisis, but have risen back to around zero. A gradual uptick is likely in coming years, albeit not to pre-crisis levels.
Global rates markets do not currently reflect this view, however. In the US, where the process is most advanced, markets are pricing in around four rate hikes over the next three years, leaving real rates in negative territory. Not only does this underestimate the probable pace of hikes by the Federal Reserve, it comes as the US central bank lays out plans to shrink its balance sheet. This should put longer-term bond prices under more pressure, as term premia normalise and yield curves steepen.
Long-dated sovereign yields can be expected to rise globally, but from a relatively low level compared to the onset of a traditional hiking cycle. The biggest repricing should come from Europe where quantitative easing (QE) is still in place, although 10-year US Treasuries could move another 50-100 basis points higher from here.
With all investments in effect priced against a “risk-free” asset, it could be argued that a rise in government bond yields might trigger a widespread decline in asset prices. Yet, while rising sovereign yields will continue to exert an influence on the price of other assets, it is far from clear that all else will swoon in sympathy.
Some corporate bond markets look expensive for this point in the cycle. Still, they are likely to provide a positive return for investors in the absence of rising defaults. Equities could perform much better than many expect as QE is unwound. For the time being at least, the likely improvement in global economic fundamentals should outweigh the impact of higher interest rates.
European equities look more attractive than their US counterparts on valuation grounds, as concerns over the influence of political populists abate. Following the victory in France of centrist and pro-European Emmanuel Macron, it seems unlikely that populist candidates will go on to win any major election in Europe this year. Depressed sentiment, international positioning and the potential for earnings re-rating also support European companies, with the possible exclusion of the UK due to uncertainty over the Brexit negotiations.
As the outlook for risk assets starts to diverge, investors will need to look at markets through a different lens than the one they have used through the post-crisis period. Dispersion, not correlation, will be the prevailing normal.
This article originally appeared in the Financial Times
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