Risk and correlation

Correlations can help us understand the degree to which variables are moving in tandem with each other. This is important if we want to get proper insight into how portfolios can be diversified. However, correlations change over time. For example, in periods of market stress, certain asset classes that normally exhibit low correlations can start to move more in tandem, while other assets might prove more independent.

One of the most important factors we have to understand is how, and to what degree, we should diversify our equity exposure. For extended periods in the past, government bonds have played a crucial role here, as they have traditionally been negatively correlated to equities and have been a low volatility asset.

These perceptions help explain why government bonds have played such an important role in traditional portfolio construction and risk analysis, which was centred on the concept of a risk-free rate, for example a 10-year developed-economy government bond yield. This was then used as a reference point for the rest of the portfolio.

With government debt levels at extremes globally, considering government bonds as a risk-free asset seems far from wise

The assumptions surrounding risk-free assets are that they have very low levels of correlation with risk assets, they have a lower return profile than risk assets and also have a very predictable return. However, few of these assumptions have rung true in recent years, while, in recent weeks, the volatility of government bonds has increased materially.

Furthermore, with government debt levels at extremes globally, considering government bonds as a risk-free asset seems far from wise. Of course, the past few years have been highly unusual, but the period underlines perfectly how volatilities and correlations can change substantially over time.

It is a similar story across asset classes. For example, gold is generally perceived to be a safe-haven asset and a hedge against inflation. Yet, in 2009 and 2010, both gold and equities rose during a period when inflation was not perceived to be a threat.

We are currently seeing interesting developments in equity markets. For example, European stocks are moving much less independently of each other. As you would expect, in periods of market stress, volatility and correlation both increase, as stock-specific risks become overshadowed by market risk and stocks start to move more dependently, in response to the increased common risk.

More recently, volatility has moved up to levels last seen just before the European Central Bank’s head Mario Draghi drew a line in the sand with his “whatever it takes” speech, in July 2012. Interestingly, correlation has moved to levels last seen as far back as 2011, when eurozone market stress reached its peak, post the great financial crisis.

There are several market factors that will have undoubtedly led to groups of stocks in the market moving in a more correlated manner. The weaker euro (the eurozone is a very export orientated economy), sanctions with Russia, the weak oil price and events in Greece are all material market developments that are leading to certain parts of the market moving more in tandem.

Why has volatility not increased to the same degree? It is difficult to say; it might be that higher correlation is not being dominated this time by market stress, but by more positive market developments, such as a weaker euro and weaker oil. It might also be that, more recently, the ECB quantitative easing programme is acting to dampen volatility.

It is currently unclear and we prefer to avoid speculating. Our focus remains on the present, rather than forecasting the future or assuming the relationships that held in the past, will hold in the future. At the moment, the broader risk environment remains characterised by economies and monetary policies that are diverging, and so policy risk remains high. Meanwhile, geopolitical risk remains centre stage, currently dominated by events in Greece, Russia and the Middle East.

Recent months have also provided some timely reminders as to the folly of forecasting. The cosy consensus around a high and stable oil price was caught by surprise, while the breaking of the Swiss franc peg also reminded us that, if you have to assume, it is best to assume that the risk environment is dynamic not static.

As fixed income appears fairly stretched and looks less likely to be able to fulfil its role as equity diversifier, we are happier to hold more cash than normal. In the meantime, there are some excellent opportunities within eurozone equities, especially in the sweet spot between attractive valuations and earnings momentum.

Anthony Rayner is co-manager of Miton’s multi-asset fund range

Key points

Correlations can help us understand the degree to which variables are moving in tandem with each other.

Volatility has moved up to levels last seen just before the European Central Bank’s head Mario Draghi drew a line in the sand with his “whatever it takes” speech in July 2012.

Higher correlation is not being dominated this time by market stress, but by more positive market developments.