CANADIAN FIXED INCOME COMMENTARY

The Diversifier’s Dilemma

Nov 10, 2018

Aubrey Basdeo shares this month's Canadian Fixed Income outlook.

 


Summary

  • Since the global financial crisis, correlations between bonds and equities have been steadily rising, driven by central banks suppressing volatility with a combination of low rates and extraordinary monetary policy in the form of quantitative easing.
  • As fixed income and equity markets seem to have shifted to risk-off, investors are struggling to find assets that move in the opposite direction from other assets, leaving portfolios exposed to synchronized losses even if they are diversified.
  • In our view, bonds are still a reliable diversifier in a market rotation, especially as we get late in the business cycle. Better balancing risk exposure in a bond portfolio is critical to realizing the benefits of diversification.

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“A rising tide lifts all boats” is one of the most often-repeated truisms in investing. It can also be accurate. During the post-recession bull market, equities and fixed-income performance was neatly synchronized, not to mention positive. That was all well and good when the tide was rising, but synchronicity is not so wonderful when the waters are flowing the other way. That’s why another truism – about the benefits of diversification – really starts to matter when the tide turns.

In a well-diversified portfolio, as one asset class declines, another should rise, mitigating risk and minimizing losses. Yet that is proving to be easier said than done. As fixed income and equity markets seem to have shifted to risk-off, investors are struggling to find assets that move in the opposite direction from other assets, leaving portfolios exposed to synchronized losses even if they are diversified. Specifically, the recent performance of stocks and bonds have been moving in the same direction: down. (See Figure 1.)

Figure 1: S&P 500 vs 30 Year Treasuries

S&P 500 vs 30 Year Treasuries

Source: Bloomberg L.P. Nov 05, 2018

In investment terms, we see this phenomenon in the correlations between asset class performance. And it is nothing new. Since the global financial crisis, correlations between bonds and equities have been steadily rising, driven by central banks suppressing volatility with a combination of low rates and extraordinary monetary policy in the form of quantitative easing (QE). (See Figure 2.)

Figure 2: Rolling 90 day correlation of U.S. 10Y Treasury and S&P 500 daily returns

Rolling 90 day correlation of U.S. 10Y Treasury and S&P 500 daily returns

Source: Thomson Reuters Datastream, Nov 05, 2018. Notes: the lines shows the correlation of daily returns of U.S. 10y Treasury returns and S&P 500 over a rolling 90 day period.

When the U.S. Federal Reserve and, latterly, the Bank of Canada began tightening financial conditions – through the U.S. Federal Reserve cessation of QE and the unwinding of its balance sheet, as well as through rate hikes – bonds sold off, as expected, but stocks gained, as all signs pointed to strong economic and earnings growth. In recent weeks, however, rising geopolitical uncertainty and trade tensions have served as a headwind to stocks, as have tighter financial conditions. The strong U.S. dollar and higher front-end rates have had a rolling negative effect on risk assets – first in emerging markets, where greenbacks strength and higher real rates have heightened financial risk, and now in developed markets, where higher short rates are offering a compelling alternative to risk assets.

During equity routs, bonds have traditionally provided a cushion for investors. This time around, they haven’t (at least not yet), as continued hawkish comments from central banks hobble fixed-income returns. Meanwhile, with the robust greenback, gold doesn’t look like a reliable safe haven, either.

So how to achieve better diversification in times like these? We see institutional investors in particular moving into off-market assets like infrastructure and private equities, but those options are generally not available to others. For them, there is no simple answer to the diversification dilemma, but rising correlations mean that investors need to be attentive to the forces at play.

In our view, bonds are still a reliable diversifier in a market rotation, especially as we get late in the business cycle. Better balancing risk exposure in a bond portfolio is critical to realizing the benefits of diversification. When equities are signaling a dramatic growth slowdown, it makes sense to overweight interest rate risk; when equities signal a growth surge, overweight spread risk.

Where are we now? Certainly, the recent signals from the equity market are that we are late in the cycle. Meanwhile, volatility might be flashing a higher probability of a tail-risk event, where we witness a significant sell-off in risk assets.

As it stands, investors basically have two choices. They might find short rates extremely attractive, primarily for income generation, but that approach will be limited in its ability to provide a counterbalance in the event of a tail-risk event. The alternative is to assume longerduration exposure with a tilt towards interest rate risk, which would provide diversification against a growth slowdown as well as an insurance policy against a tailrisk event.

For those reasons, we are constructive on the bond market. We see it priced appropriately, with a bias toward downside risks as higher rates bite into debtladen consumers’ ability to spend. We continue to believe the Bank of Canada and the U.S. Federal Reserve are likely to take a pause in the tightening cycle early in 2019, as growth cools and inflation expectations remain well anchored. Going forward, we expect a flatter yield curve, monetary tightening and a corresponding liquidity drain, and positive front-end rates to persist into the late cycle, creating more volatility in risk assets.

If that turns out to be the case, then benchmark duration in fixed income will help to diversify a portfolio – even as the tide turns.

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Aubrey Basdeo
Head of Canadian Fixed Income, BlackRock
Aubrey Basdeo, Managing Director, is a member of the Strategy Team within BlackRock's Global Fixed Income group. He leads the product strategy effort in Canada ...