A safe haven is the holy grail of investing. Assets that can hold their value – or even appreciate – in periods of market turbulence are highly prized by investors. Historically these have included gold, the Swiss Franc, the US Dollar and US Treasuries.
But, in today’s unusual investing world that includes unconventional measures such as quantitative easing (QE), political shocks such as Brexit and increasing tensions among western allies over trade balances; does such a thing actually exist anymore?
If we start off with gold, it is pretty evident that when equity market volatility – measured by the well-followed Vix index – spikes higher, the metal seems to get a boost.
However, the long-term chart does not necessarily give one a high degree of confidence that gold will necessarily hold on to its value in an equity market selloff. Certainly steep falls in UK equities seem to be associated with a rising gold price (in GBP terms), but the relationship is pretty noisy and there are times when weaker equities have been linked to a weaker gold price. This was particularly true during the financial crisis in 2008 when investors panicked and sold off all asset classes, including so-called safe havens as the money was needed to meet cash calls elsewhere.
Moreover, an environment of rising interest rates may also be a headwind for precious metals as it increases investors’ cost of carry. However much some investors consider it an insurance policy, gold will always be a non-yielding asset involving a cost in ownership.
We could run the same type of chart for the US Dollar, US Treasuries and the Swiss Franc with much the same (noisy) outcome. So, where does this leave us?
Well, hopefully in a better position than would appear at first blush.
One of the key features of the world of super-low interest rates and QE has been the high degree of correlation between asset classes and the constituent members of those asset classes. Intuitively this makes sense.
Central banks print money and use the cash to buy mainly government bonds and in doing so depress their yields. This, in turn, makes corporate and other higher-yielding bonds more attractive on a relative basis.
As investors switch into these assets, they in turn become more expensive. With the price investors are prepared to pay for a given income stream in the bond market now significantly higher, the price equity investors are prepared to pay for a given equity earnings stream is now similarly higher and this is felt in higher earnings multiples and share prices. It explains, incidentally, why shares were able to rally over the past couple of years without any corporate earnings growth. We can go on and include other asset classes such as property in this asset-substitution channel.
A result of this asset-price reflation, investment returns have been high, but so have correlations. This has had the effect of depressing risk-adjusted returns. It has been particularly true of the equity/bond relationship.
Looking at history
Historically, a good environment for equities (better growth momentum, rising corporate earnings and better pricing power) would usually be reflected in higher bond yields. The converse would also apply, making bonds a good hedge in a poor environment for risk assets. However, over the past five years, declining bond yields have been a boon for equity valuations (see chart) and has made bonds a poor hedge in against an equity market downturn. In fact, on occasion, rising bond yields have been the cause of equity market weakness.
This has caused multi-asset investors a real headache and has made equity investors – particularly those in the so-called defensive sectors of the equity market – spend almost as much time following the bond market as their fixed-income counterparts. Elsewhere, high correlations have made returns in the so-called alternative asset universe hard to come by.
Now that bond prices have been falling, does this mean that equities will follow them lower, and that the positive correlation between stocks and bonds will continue to hold? In my view the answer is no.
Within the developed world central banks have either signalled that QE is ending, or have much less enthusiasm for it. As a rule the more a central bank’s balance sheet increases, the less it is able to ease financial conditions.
In addition, super low market rates can have potentially harmful negative externalities. It is often claimed that they can reduce a saver’s propensity to spend (more cash is required for the same income steam) and have also been linked to poor productivity growth as it may encourage the creation of so-called zombie companies, unable to function without the steady drip feed of easy money. Thus, while the European Central Bank and the Bank of Japan are likely to (grudgingly) keep buying financial assets for the balance of this year, the Bank of England has nearly finished its bond-buying operation and, not only has the US Federal Reserve embarked upon a tightening cycle, it is also having an active internal debate about when to start shrinking its balance sheet.
Collapsing correlations
As a result, central banks are starting to have less influence over asset prices, with the result that traditional macro drivers of cross asset performance – growth, earnings and inflation to name but three – are beginning to reassert themselves. Correlations are now falling markedly. I am indebted to Morgan Stanley for its Global Correlation Index, which is an average of regional correlations and cross-asset correlations encompassing equities, credit, bonds and foreign exchange. It is evident from the chart that cross-asset correlations are the lowest in more than a decade, backing up my intuition that central bank influence is waning.
Elsewhere, not only have cross-asset correlations collapsed, but so has the correlation between individual equities and the broad market and, again, this shows that bottom-up fundamentals are gaining the upper hand in driving individual equity returns.
Where does all this lead us in finding a safe place to invest in times of market turbulence? Well, if the foregoing is at all correct we should not seek it in any one asset class, but look instead at a globally well diversified multi-asset portfolio combing top down asset allocation supported by bottom up stock selection.
Jon Cunliffe is chief investment officer of Charles Stanley
Key points
It is not clear, due to certain macroeconomic factors, that safe havens exist any more.
Investment returns have been high, but so have correlations.
Central banks have much less enthusiasm for QE.
