The financial crisis has led to some unusual behaviour from asset classes and created a twofold problem, leaving investors with some difficult questions to answer
The two graphs below tell an important part of the stories for two recent crises. The first, 2000-2005, covers the period of the Dot Com Crash and subsequent recovery. The second, 2008-2013, covers the aftermath of the collapse of Lehman Brothers nearly five years ago.
As the graphs clearly show, these two periods have relatively little in common, save sharp equity market falls marking the start of the downturn. Five years after the dot com bubble burst equity markets had still failed to capture their earlier heights, while corporate and government fixed income remained largely unscathed by the downturn returning an average of 30 per cent and 20 per cent respectively. Furthermore, between 2000 and 2005 the average GDP annual growth rate in Britain was above 3 per cent.
Contrast that with what we have seen in the aftermath of the so-called Great Recession. Although, unlike in the early naughties, almost all asset classes were hit by the initial downturn investors had made up their losses in just over a year. This is all the more impressive because average annual economic growth over the period was negative.
The returns have been impressive. An average high yield bond or equity fund would have returned almost 50 per cent over five years while even the traditionally slow and steady corporate bond and gilts sectors have gained by an average of 35 per cent. Just as significant as the performance, however, has been the increase in correlation between assets.
So what are we to make to this stellar performance set against a stagnant economy?
It is clear that the policy response to the financial crisis, in particular large scale asset purchases by central banks, has prompted some unusual behaviour from asset classes, both their individual performance compared to historical data and their relationship to each other. The problem now is twofold, however: 1) by bringing forward the future returns across the asset class spectrum there may be nowhere to hide in case of a market shock; and 2) if the bubble of 2008-2013, unlike the tech stock boom and bust, was one of inflated economic growth, then the recovery may continue to be sluggish.
The spike in correlation between asset classes has been a concern
From an investor’s point of view this situation poses some difficult questions.
The spike in correlation between asset classes has been a concern,”says Ben Willis, head of research at Whitechurch Securities. The difference between past crises and now is that we’ve got an artificial market at the moment with huge central bank stimulus. So although some assets may look expensive, we don’t know whether they may be able to hold these levels.”
What is clear is that bond yields across the risk spectrum are being squeezed as central bank purchases force investors out of government debt and into other assets. This has prompted some large flows into equity income stocks where the dividends are seen as more sustainable.
Yet for funds with a risk-averse investor base the shift up the risk spectrum in order to meet yield requirements poses a problem. This was precisely the point that Toby Nangle, head of multi-asset at Threadneedle, made in a recent note:
“By bidding yields on government bonds down to current levels, monetary policymakers have largely extinguished government bonds as an effective portfolio hedge. Investors can now decide either to increase their risk appetite on a structural basis and hold more risky assets (that is to say assets that are positively correlated with equities), or increase their cash positions and hold less equity than they would otherwise do to retain the same level of portfolio risk.”
Matching the risk tolerance of investors with their anticipated returns is therefore becoming a much more difficult proposition. Holding additional cash in the current environment of near zero interest rates is effectively to suffer a real terms loss on that portion of the portfolio. Moreover the correlation of cash with other asset classes is 0, not negative, so it is a far from perfect portfolio hedge.
The market appears to be crying out for a yielding asset that has some of the characteristics of government debt – particularly its use as collateral. Indeed there are signs that this has already caused investors into some unusual behaviour such as shifting into crude oil inventories in the US.
Governments and central bankers need to look again at the current policy mix, and in particular the idea that monetary policy can “offset” fiscal consolidation, if they are to address the perverse incentives maintaining it could provide.