Cazenove’s Le Jehan: Changing correlations, safe havens and portfolio hedges


The pullback in markets over the last few weeks was perhaps not unexpected but has highlighted a different trend to similar episodes in recent years – something that we’ve been discussing over the last few months, but appears to have caught some investors by surprise.

Of course, the obvious difference in markets in recent weeks has been the similar direction taken by both government bonds and equity markets – a retreat of equity markets accompanied by widening sovereign yields, confounding those who continue to argue for the ‘safe haven’ qualities of government bonds in ‘risk off’ periods.

As interesting has been the, albeit tentative, signs of underperformance of the much loved ‘quality & yield’ story, with certain more traditionally defensive equity sectors lagging more cyclical areas in down markets. Again, a dislocation of once assumed market behaviour.

Whilst economic data does not yet reflect such, we are arguably seeing markets adjust to the idea of modest growth and indeed inflation at some point in the future. Continued talk of the potential tapering of US QE later in the year, as and when the outlook for the economy improves, has seen markets reassess their view of where future interest rates may be and seen bond yields widen accordingly. All else equal, widening bond yields shrink the yield premiums of equity over bonds and thus theoretically lessen the attractiveness of the equity income story that has dominated markets in recent time. So perhaps recent moves are understandable.

All of this brings us back to a topic we’ve mentioned in previous blogs but don’t apologise for mentioning again here. The breakdown of ‘normal’ correlations we’re seeing perhaps reflects an appreciation of the significant upward adjustments in relative valuations over recent months and years, particularly in bond markets and other ‘safe havens’. Indeed, an appreciation that risk is a function of the price you pay – a theme always prevalent in our thoughts.

To us, the upside on offer from sovereign bond yields at all-time lows after 30 years of a bond bull market has not compensated for the increased risk in holding such bonds and the potential downside for some time, just as the relative multiples applied to some of the more defensive areas have begun to look increasingly unattractive as investors continued to bid up the ‘lower risk’ areas. Market movements in recent weeks suggest that this idea is tentatively becoming more widely accepted.

All of this may not be new news – merely highlighting how markets adapt and change. But an appreciation that correlations between and within asset classes are altering has important implications for investors. The move in government bonds in particular highlights how selecting appropriate portfolio hedges is critical, as those who have talked up the defensive qualities of the sovereign bond market in recent months are beginning to experience. For us, the number of attractive hedges or even ‘safe havens’ has undoubtedly diminished.

Alongside some tactically astute relative-value hedge funds, cash remains a useful source of liquidity and optionality in a period where traditional hedges or even classically defensive funds may not offer the protection investors once relied upon.

Joe Le Jehan is a fund manager in Cazenove Capital’s multi-manager team