Asset correlations and portfolio risk: what a difference a quarter makes

The last quarter of 2018 witnessed dramatic changes in the risk environment and multi-asset class correlations. At the start of the period, markets were still concerned about high inflation caused by strong labor market conditions and wage growth. As a result, risk in Axioma’s global multi-asset class portfolio at the time showed few diversification benefits, as inflation fears were still at the forefront of investors’ minds. Traders have since drastically lowered their interest-rate expectations—fueled by ‘dovish’ Fed comments—and the latest risk climate has been dominated by strong stock market volatility and ‘flight-to-quality’ movements.

In our weekly Multi-Asset Class Risk Monitor Newsletters in early October, we noted that US Treasury yields had risen to their highest levels in more than 7 years, buoyed by strong producer price and wage growth and record highs at the stock market. Combined with healthy labor market and service sector data, this kept inflation fears alive, which, in turn, fueled expectations of aggressive central bank rate hikes.

Higher interest rates and yields increased the attractiveness of the US dollar, which had gained 10% against a basket of foreign currencies from February to November. The greenback was further supported by heightened political uncertainty on the other side of the Atlantic—namely the Italian budget spat with the European Commission, the so-called ‘yellow vest’ protests in France and the frequent setbacks in the Brexit negotiations. At the same time, stock and bond markets alike were hit by the concerns over rising consumer prices.

This environment was particularly bad for US investors. Falling share prices could no longer be offset by gains in fixed-income assets. Simultaneously, declines in non-USD asset values were amplified by exchange rate losses against the appreciating dollar. In Axioma’s model portfolio, this was reflected in a significantly reduced diversification effect and large percentage risk contributions from non-US developed and emerging-market equities, which were both around twice their respective monetary weights. The positive correlation between stock prices and exchange rates also resulted in a large risk share of non-USD sovereign and corporate bonds. Even US Treasuries and investment-grade issues contributed positively to overall portfolio risk. JPY cash was the only major asset class in the portfolio that actively reduced volatility.

The picture was completely different at the beginning of 2019. Since the peak in early October, the 10-year Treasury benchmark had fallen 40 basis points, as bond traders revised their interest rate expectations. Long bond yields began their descent in mid-November, when the first Fed rate setters started to shift their stance on rate raises towards “neutral”. This was reaffirmed in a speech by Federal Reserve Chairman Jay Powell at the end of the month, in which he remarked that the bank’s target rate was “just below the broad range of estimates of the level that would be neutral for the economy.” Final confirmation arrived shortly before New Year’s Eve in the form of the so-called ‘dot-plot’, which illustrates the short-term interest rate projections of Federal Open Market Committee members. The median forecast is now for two more raises in 2019, down from three in the previous poll in September.

With the very short end held in place by central bank action, the downward revision of future interest rate expectations led to a significant flattening of the US Treasury curve and even to a piecewise inversion between the 1-year and 5-year points. Long bond yields dipping below short-term interest rates is usually seen as a precursor of a recession, although, as we noted in our recent whitepaper The Year of the Central Banks and feature article in the Financial Times (£), it can take several months until share prices start to fall significantly and before GDP growth turns negative.

The 16% drop in the US stock market over the course of December dramatically increased equity volatility in the portfolio, resulting in a 70% risk contribution from US share holdings alone. Combined with the non-US developed and emerging markets buckets, global equities accounted for 97% of total portfolio volatility, although a large part of the local losses was absorbed by exchange-rate gains. One of the biggest beneficiaries of the flight-to-quality environment was the Japanese yen, which appreciated over 5% against its American rival during the last month of 2018. Its strong, consistently negative correlation with the US stock market was therefore reflected in a negative contribution from the JPY cash holding. Other safe-haven assets—mostly gold and global sovereign bonds—also actively reduced portfolio volatility.

More recently, the market focus is starting to shift once more toward political risk in Europe, which means that the respective currencies will no longer be negatively correlated with the US stock market. This, in turn, reduces potential diversification benefits for American investors from investing in non-USD assets. However, the inverse relationship between stock and bond prices is likely persist, as long as the political uncertainty remains.

For a more detailed review of the major drivers of portfolio risk in the last quarter of 2018, register for our Axioma Insight™ Quarterly Multi-Asset Risk Review webinar. You may also subscribe to our weekly Risk Monitor newsletters.

Christoph Schon, CFA, CIPM

Christoph Schon is the Executive Director, Applied Research for EMEA at Axioma, where he generates insights into recent risk trends with a particular focus on fixed income and multi-asset class analysis. Christoph has been in the portfolio risk and performance analysis space for more than 10 years, having previously worked for Lehman Brothers/Barclays POINT and UBS Delta.