In a multi-asset portfolio, risk is a function of two things – the volatility of the underlying investments and their correlation with each other.
Assets commonly regarded as having the ability to diversify away equity risk actually completely fail to deliver when they are needed the most – during rapidly falling equity markets.
Defining market conditions using our market stress indicator (MSI), we can show how only gilts and other high quality bonds provide portfolio diversification – low volatility and strong negative correlation with UK equities – during periods of extreme market tumult. Our MSI has only read 4.5 or above on 13 per cent of days since 1990.
Empirically, even gold can let investors down in early equity slumps, and other commodities, property and overseas equities only increase risk in such events, as their volatilities and correlations with UK equities polarise.
Against the consensus, we believe that gilts will be one of the lowest cost equity diversifiers in the next 12-24 months – for example, helping investors manage the risks without eroding portfolio returns.
Fundamentally, this outlook rests on policy. The Bank of England’s Monetary Policy Committee (MPC) remains deeply sceptical of the outlook for growth in the UK. Our models for economic growth maintain that the UK will barely keep its head above water in 2013, while we envisage further soft patches in consumer-sensitive sectors such as housing.
Furthermore, our policy pressure index analyses a number of indicators of inflationary pressures alongside signs that the economy is overheating or overleveraging. A reading below zero tells us that officials need to loosen monetary conditions. The current reading is negative.
In spite of £375bn of quantitative easing (QE), a policy rate that cannot go meaningfully lower and a scheme to encourage banks to start lending, the index still maintains that the economy needs even more stimulus. Against such a stark backdrop we believe that policymakers will not tolerate rising gilt yields, due to the knock on effects to mortgage costs and the cost of capital projects for firms.
Most likely, the MPC will capitulate on a further round of QE, as the government refuses to ease fiscal austerity.
Robert Jukes is global strategist at Collins Stewart Wealth Management
